Caf 02

Certificate in Accounting and Finance Stage Examination
The Institute of 24 September 2020

Chartered Accountants 3 hours – 100 marks
of Pakistan Additional reading time – 15 minutes
Introduction to Economics and Finance

Instructions to examinees:
(i) All the Questions from Section A are compulsory.
(ii) Attempt any FIVE out of SEVEN Questions from Section B.
(iii) Answer in black pen only.
(iv) Multiple Choice Questions must be answered in answer script only.
Section A
Q.1 (a) What is planned economy? State any three drawbacks of planned economy. (04)
(b) Define ‘Capital formation’ and explain the stages involved in the process of capital
formation. (04)
Q.2 (a) What is ‘Diminishing marginal utility’? Explain the law of diminishing marginal
utility with the help of a schedule and the diagram. (07)
(b) List any four factors which may determine price elasticity of demand. (02)
Q.3 (a) What do you understand by the term ‘Economies of scale’? Describe any four ways
by which a firm may achieve internal economies of scale. (06)
(b) State how a firm may increase its overall profitability by exercising price
discrimination. (06)
Q.4 Briefly describe the following diagram and the concept it depicts. (06)
Introduction to Economics and Finance Page 2 of 4
Q.5 Select the most appropriate answer from the options available for each of the following
Multiple Choice Questions (MCQs). Each MCQ carries ONE mark.
(i) Which of the following features is more related to free market economy as compared
to planned economy?
(a) An incentive to innovate
(b) An even distribution of wealth
(c) Full employment of labour
(d) Production of goods for the benefit of the society as a whole
(ii) Micro economics does NOT cover:

(a) consumer behaviour (b) factor pricing
(c) general price level (d) product pricing
(iii) Which of the following statements is NOT correct?

(a) The different combinations of goods can be shown in the form of a budget line
(b) To work out where to draw the budget line it is necessary to divide the price of
each good with consumer’s total income
(c) Any point to the left of the budget line is affordable
(d) The slope of budget line is representative of the relative price between the two
goods
(iv) Under perfect competition, the supply curve of a firm is equal to:
(a) MR curve (b) AR curve
(c) MC curve (d) AC curve
(v) Which of the following is NOT considered to be an assumption of the law of

diminishing marginal utility?
(a) Rational consumer (b) Continuous consumption
(c) No change in quality of goods (d) Ordinal measurement
(vi) In a business cycle, the stage which eventually leads the economy to the state of
inflation is:
(a) Boom (b) Down turn
(c) Recession (d) Trough
(vii) Which of the following is NOT a part of Adam Smith’s canon of taxation?
(a) Equality (b) Economy

(c) Objectivity (d) Convenience
(viii) A reduction in the demand for coal miners is likely to lead the economy to the
following type of unemployment:
(a) frictional (b) structural
(c) voluntary (d) cyclical
(ix) Which of the following would increase the value of multiplier?

(a) The propensity to spend extra income on domestic goods and services is high
(b) The marginal rate of tax on extra income is low
(c) The propensity to spend extra income rather than save is high and consumer
confidence is high
(d) All of the above
(x) The crowding out effect is caused by a:

(a) rise in interest rates reducing private sector investment
(b) rise in interest rates reducing public sector investment
(c) fall in interest rates increasing savings
(d) fall in interest rates reducing consumption
(xi) The currency rate of exchange of a country will tend to increase, if:
(a) the demand for country’s goods and services increases in the foreign markets
(b) the value of the dominant reserve/transaction currency appreciates
significantly
(c) the supply of currency of that country in foreign exchange markets increases
(d) citizens of that country increase import of foreign goods and services
(xii) Which of the following instruments are NOT traded in the capital market?
(a) Corporate bonds (b) Mutual funds

(c) Mortgages (d) Shares
(xiii) In the Keynesian theory of demand for money, the transactions demand for money
is determined by:
(a) the rate of interest
(b) the level of consumers’ income
(c) expected changes in consumer prices
(d) the amount of money in circulation
(xiv) A country’s balance of payment position exhibits:

(a) whether the country saves enough to pay for its imports
(b) whether the country produces enough economic output to pay for its growth
(c) whether the country's currency value is appreciating or depreciating
(d) all of the above
(xv) Which of the following is a financial intermediary?

(a) Commercial bank (b) Federal Government
(c) State Bank of Pakistan (d) Stock exchange
Section B
Q.6 (a) Draw a diagram of the circular flow of national income in a two sector economy
clearly identifying the real flow and money flow. (04)
(b) List down any three factors which cause a shift in:
(i) aggregate demand curve. (03)
(ii) short-run aggregate supply curve. (03)
Q.7 (a) What do you understand by ‘Cost-push inflation’? Briefly describe any four causes of
cost-push inflation. (07)
(b) Describe any three limitations of multiplier. (03)
Q.8 Discuss the concept of inflationary gap in an economy with the help of a diagram. (10)
Q.9 (a) Briefly describe ‘Progressive tax’, ‘Regressive tax’ and ‘Proportional tax’. (03)
(b) State any four characteristics which are necessary for a good tax policy. (02)
(c) Identify and describe five main objectives of fiscal policy. (05)
Q.10 (a) Briefly describe any five roles which State Bank of Pakistan performs as banker to
the Government. (07)
(b) What do you understand by the ‘Quantity theory of money’? (03)
Q.11 (a) What is ‘Keynesian liquidity trap’? Identify any two policies which may help in
overcoming the liquidity trap. (03)
(b) What is meant by the term ‘Money market’? Briefly describe ‘Commercial paper’
and ‘Certificate of deposits’ which are traded on money market. (04)
(c) Describe the functions of money. (03)
Q.12 (a) State how a government may stop exchange rate from falling? Support your answer
with the help of a diagram. (06)
(b) Briefly discuss the constituents of capital/financial account. (04)
(THE END)
Suggested Answers
Certificate in Accounting and Finance – Autumn 2020
Ans.1 (a) Planned economy:

It is a type of economic system in which allocation of resources is decided by the
government rather than markets.
Drawbacks of planned economy:

(i) Lack of profit motive and competition makes the economy inefficient.
(ii) Bureaucratic and slow to respond to changing needs or technology.
(iii) Loss of consumer sovereignty to planners reduces welfare.
(b) Capital formation:

Capital formation is the net capital accumulation for a particular country and
refers to the additions or increase in the stocks of capital in that country. Capital
goods include machines, tools, factories, transport equipment, materials,
electricity, etc.
Stages involved in the process of capital formation

The process of capital formation involves the following three stages:
(i) Creation of savings:

When the average level of income is high then people tend to save more. An
increase in the volume of real savings releases resources which otherwise
would have been devoted to the production of consumption goods.
(ii) Mobilization of savings:

It involves transfer of savings from the households to businesses for
investment.
(iii) Investment of savings:

Investment of savings in real capital is integral for the capital formation.
This can only happen if there are enough entrepreneurial ventures and
businesses that are willing to take risks and embrace uncertainty.
Ans.2 (a) Law of diminishing marginal utility:

It means that additional benefit which a person derives from a given increase of
his stock of a commodity diminishes with every increase in stock that he already
has.
Explanation with the help of schedule and a graph:

We assume that a person is very thirsty. He takes the glasses of water successively.
The marginal utility of the successive glasses of water decreases, ultimately, he
reaches the point of satiety. After this point the marginal utility becomes negative,
if he is forced further to take a glass of water. The behaviour of the consumer is
indicated in the following schedule:
Units of commodity Total utility Marginal utility (MU)

1st glass 10 10
2nd glass 18 8
3rd glass 24 6
4th glass 28 4
5th glass 30 2
6th glass 30 0
7th glass 28 -2
The law of diminishing marginal utility can be explained by the following diagram
drawn with the help of above schedule:
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In the above diagram, the marginal utility of different glasses of water is measured
on the y-axis and the units (glasses of water) on X-axis. The marginal utility curve
has a downward slope. It intersects the X-axis at the point of 6th unit of the
commodity (point "F") where the marginal utility becomes zero. When the MU
curve goes beyond this point, the MU becomes negative. So there is an inverse
functional relationship between the units of a commodity and the marginal utility
of that commodity.
(b) Factors which may determine price elasticity of demand:

Following are the factors which may determine price elasticity of demand:
(i) Nature of the commodity
(ii) Number of substitutes
(iii) Goods having several uses
(iv) Durable goods and perishable goods
Ans.3 (a) Economies of scale:

Reduction in cost per unit resulting from large scale production are known as
economies of scale.
Internal economies of scale can be achieved in the following ways:

(i) Technical economies:
As the firm expands it can use larger and more efficient machines resulting
in greater efficiency and economy.
(ii) Managerial economies:

Larger firms can employ specialist managers to optimise the use of
resources. The cost per unit of clerical and administrative procedures will
also be lower as output grows.
(iii) Trading/commercial economies:

Larger size enables the firm to buy in bulk and sell in bulk, reducing both
the costs of buying and selling. Large businesses have bargaining
advantages and are accorded a preferential treatment by the firms they deal
with.
(iv) Financial economies:

Larger firms have better credibility and can offer better security, making
them a better risk for lenders thus reducing interest rates and financing
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costs.
(b) How a firm can increase its overall profitability by exercising price discrimination:
Price discrimination is profitable if the firm identifies and operates in markets
where elasticity of demand in one market is different from elasticity of demand in
the other market. Or the firm splits up the groups of buyers and prevent goods
from being resold between them.
The monopolist charges a higher price in the market where elasticity is low and
charges a lower price where elasticity is high.
The marginal revenue in the market with high elasticity of demand is greater than
the marginal revenue in the market where elasticity is low.
The monopolist therefore transfers some units of the commodity from the market
where elasticity is low to a market where elasticity is high until the marginal
revenues in both the markets are equal.
The market from which the units are transferred will experience a rise in price and
the market to which the units are transferred will experience a fall in price.
But due to difference in elasticity, marginal revenue (MR) sacrificed will be much
lesser than the MR gained and hence the monopolist would be able to maximize
the overall profitability.
Ans.4
The above diagram demonstrates the concept of consumer equilibrium using

indifference curve.
(i) AM is the budget line (consumer’s price line). Each point on the line represents a
combination of quantities of products A and B which the consumer can buy at the
prevailing prices, given the amount of money the individual has to spend on the
two products. Hence the equilibrium must be on some point on this line.
(ii) Each point on the indifference curve represents the same level of satisfaction. The
level of satisfaction increases as the individual moves from lower indifference
curve to higher indifference curve i.e. the individual is at a lower level of
satisfaction at the combinations represented by IC1 and at a higher level of
satisfaction when on IC2 and so on.
(iii) IC3 is the highest indifference curve to which the individual can go, given the
money and the prices of the goods in the market. The price line is tangent to the
indifference curve at point P which is the point of maximum satisfaction because
all other points on the curve are beyond the budget line.
The indifference curve IC4 is unattainable as it is beyond the budget line AM.
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(iv) Thus the consumer will be in equilibrium when the individual purchases OH
quantities of product A and OJ quantities of product B.
Ans.5 (i) (a) An incentive to innovate

(ii) (c) general price level
(iii) (b) To work out where to draw the budget line it is necessary to divide the price
of each good with consumer’s total income
(iv) (c) MC curve
(v) (d) Ordinal measurement
(vi) (a) Boom
(vii) (c) Objectivity
(viii) (b) structural
(ix) (d) All of the above
(x) (a) rise in interest rates reducing private sector investment
(xi) (a) the demand for country’s goods and services increases in the foreign markets
(xii) (c) Mortgages
(xiii) (b) The level of consumers’ income
(xiv) (d) all of the above
(xv) (a) Commercial bank
Ans.6 (a) Circular flow of national income in a two-sector economy:
(b) (i) Factors causing a shift in aggregate demand curve:

Following are the factors which causes a shift in the aggregate demand curve.
 Consumers have more income and therefore spend more in the
economy
 Firms are producing at optimum and begin investing in the economy
 The government increases its expenditure on infrastructural projects
(ii) Factors causing a shift in short-run aggregate supply curve:

Following are the factors which causes a shift in the short-run aggregate
supply
 Change in factor productivity of both labour and capital
 Change in size and quality of capital stock, through investment
 Change in size and quality of the labour force
Ans.7 (a) Cost-push inflation:

In cost-push inflation, the prices of goods rise due to persistent increase in the cost
of production of goods, while their demand remains consistent.
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Causes of cost-push inflation:
(i) Rising labour costs:

When level of unemployment in an economy is low, skilled labor would be
in a position to demand higher wages which would give rise to cost-push
inflation.
(ii) Expectations of inflation:

When people in an economy anticipate higher inflation, they may demand
higher wages to protect their real income. Higher wages would increase the
costs to a firm which would ultimately fulfil the expectation of higher
inflation.
(iii) Component costs:

An increase in the price of raw materials and other inputs would give rise to
cost-push inflation.
(iv) Higher indirect taxes:

Imposition of indirect taxes would result in higher costs for the firms which
would ultimately pass on to end consumers resulting in cost-push inflation.
(b) Limitations of Multiplier:
(i) Efficiency of production/Elasticity of supply:

If the production system of the country cannot cope with increased demand
for consumption goods and make them readily available, the incomes
generated will not be spent as envisaged.
(ii) Regular investment:

The value of the multiplier will also depend on regular repeated investments.
A steadily increasing level of investment is essential to maintain the
momentum of economic activity.
(iii) Leakages:
Leakages from the circular flow of income would lower the value of
multiplier and extra spending in the economy would have nominal effect,
particularly where there is a high marginal propensity for imports.
Ans.8 Inflationary gap arises when consumption and investment spending are greater than the
resources at full employment. At this level, changes in the aggregate demand will cause
price changes instead of any variation in real output.
The inflationary gap can be explained with the help of following diagram:
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An increase in government spending causes aggregate demand (AD) to shift outward to

AD2. This causes the equilibrium in the economy to move from point A to point B i.e.
beyond LRAS, which is the productive potential of the economy.
This increases the price level from P1 to P2 because if demand increases, consumers on
the aggregate are willing to pay a higher price for goods.
However, equilibrium at point B is unsustainable. To produce this level of output there

would be a shortage of labour in the economy. In the long run, this will increase the
wages, causing a shift in the level of SRAS towards left.
This takes the economy from B to C and increases the price level from P2 to P3.
However, a price rise does not equate to inflation. A persistent increase in price (i.e. two
or more) results in start of inflation.
This therefore means that whenever output is beyond the LRAS, there is a tendency for
inflation to occur. Therefore, it is known as the inflationary gap.
Ans.9 (a) Progressive taxation:

It refers to a situation where the percentage of income paid in taxes increases as
income increases. The principle of progressive tax is: “higher the income, higher
the rate.”
Regressive taxation:
A tax where lower income persons/entities pay a higher fraction of their income as
taxes than higher income persons/entities.
Proportional tax:
Also called a flat-rate-tax is charged at the same percentage on all income levels i.e.
the tax as a percentage of income remains constant as income increases.
(b) Characteristics of a good tax policy:

The characteristics of a good tax policy are:
(i) persons should be required to pay taxes according to their ability i.e. it
should be equitable.
(ii) the tax should be certain and easily understood by all concerned.
(iii) the payment of tax should ideally be related to how and when people
receive and spend their income.
(iv) the cost of collection should be nominal relative to the yield.
(c) Objectives of fiscal policy:

Following are the main objectives of fiscal policy:
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(i) High level of employment: The state expenditure are directed towards
public projects thereby creating employment with productivity.
(ii) Resource mobilization: Fiscal mechanism attempts at resource mobilization

by creating a climate conducive to savings and investments, by influencing
their relative profitability.
(iii) Resource allocation: A fair share of resources is allocated to different sectors

and regions through the budgetary mechanism.
(iv) Economic stability: Undesired pace of inflation or deflation is controlled by

way of taxation and government spending.
(v) Income distribution: Fiscal policy is a combination of taxation and relief

measures which are used to correct imbalances resulting from the unequal
distribution of ownership of income earning assets.
Ans.10 (a) State Bank of Pakistan is the banker to the Government and in that capacity
performs the following functions:
(i) Issuer of currency:

The State Bank has monopoly of issuing currency which is done keeping in
view the overall objectives within an economy.
(ii) Banker to the government:

The State Bank offers advice and funding to the government for financing
projects in the same way a commercial bank would do to its customers.
(iii) Regulator of the banks:

State Bank regulates the banks through banking laws and by means of
monetary policy instruments.
(iv) Exchange rate controls:

The State Bank has a control over country’s foreign currency reserves. It uses
them to overcome short-term exchange rate volatilities and inefficiencies.
(v) Establishment of specialized banks:

In some cases, State Bank allows the creation of banks to serve a particular
purpose, usually not for commercial means. For example, agricultural bank
to provide funds to farmers at subsidized interest rates.
(b) Quantity theory of money:

Quantity theory of money states that there is a direct relationship between
changes in the money supply and the rate of inflation. The theory is based on
equation MV=PT.
MV is the value of total expenditure in a period which must be equal to the value of
goods and services sold in the same period which is PT. The equation is useful as
an explanation of inflation when certain assumptions are made and which, if
accepted, means that the average price level (P) is solely determined by changes in
the money supply (M).
Ans.11 (a) Keynesian liquidity trap

Keynesian liquidity trap is a situation where savings rates are high despite very
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low interest rates, causing monetary policy to be ineffective.
The two policies that may help in breaking out of liquidity trap are as follows:
Fiscal policy:
It is an important instrument in raising aggregate demand, for example running a
larger budget deficit by increasing public expenditure or reducing taxes.
Rising inflation expectations:

High rate of inflation would cause savings to be worthless. This will act as
disincentives for hoarding of cash, as its real value will decrease. Therefore
consumption will increase.
(b) Money market:

It is the financial market for raising short-term credit.
Both ‘Commercial paper’ and ‘Certificate of deposits’ are the instruments of money
market:
(i) Commercial paper:

Commercial paper is an unsecured short-term loan issued by the
company/corporation usually in denominations of 100,000 somewhat
restricting access to small investors. It is issued with the promise to repay
the holder a certain amount by a certain date.
(ii) Certificate of deposits:

These are time deposit with a commercial bank, whereby after a fixed time a
certain level of money will be returned to the holder. This has a slightly
higher yield because the default risk is higher with a bank, than with the
government.
(c) Functions of money:

There are four functions that money undertakes in modern society:
(i) To act as a medium of exchange:
Allowing economic agents to exchange goods without the need to barter.
(ii) To act as a unit of account:

Allowing people to compare the relative price of goods and services through
a common denomination.
(iii) To act as a store of value:

Allowing people to forgo immediate consumption if they have surplus
resources, and to retrieve it at a later date for consumption.
(iv) To act as a standard of deferred payments:

Allows people to consume goods and services in the current time period,
whilst continuing to pay in future periods.
Ans.12 (a) How the government may stop exchange rate from falling:
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Suppose the government wishes the rate to be at Rt. Policy options are:
 Increase the domestic interest rate and hence shift the demand curve for
rupees from D to D1.
 Purchase the surplus rupees (Qs-Qd) using foreign exchange reserves.
Deflate the economy to reduce the demand for imports. This will shift the supply
curve of rupees from S to S1.
(b) Components(Constituents) of capital/financial account:

Following are the components of capital/financial account:
(i) Real foreign direct investment:

A firm setting up a factory in another country.
(ii) Portfolio investment:

a domestic investor buying shares in a business that is already established. Such
investors have little or no control over these companies.
(iii) Financial derivatives:

financial instruments where the underlying value is based on another asset.
(iv) Reserve assets:

these are foreign financial assets held by Central Bank which uses them to cover
deficits and imbalances.
(THE END)
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The Institute of 5 March 2020


Instructions to examinees:
(iii) Answer in black pen only.
Section A
Q.1 (a) Identify and briefly discuss any four features which differentiate a market operating
under perfect competition from a monopoly. (06)
(b) What would be the effect of a rise in price of a substitute good on the equilibrium
market price of a good that it is being substituted for? Illustrate your answer with the
help of a diagram. (06)
Q.2 (a) Discuss any four essential features of ‘Islamic economic system’. (04)
(b) What is ‘Division of labour’? Describe any three disadvantages of division of labour. (04)
Q.3 (a) Briefly explain the concept of Relatively Inelastic Demand by using the diagram. (03)
(b) Briefly describe any four factors which are responsible for the success or failure of a
price cartel under oligopolistic market. (04)
Q.4 Discuss the concept and various stages depicted by the following diagram. Also identify the
stage in which rational decision is possible. (08)
(i) The horizontal demand curve parallel to x-axis implies that elasticity of demand is:
(a) zero (b) infinite
(c) equal to one (d) between zero and one
(ii) Which of the following will NOT cause a shift in the Production Possibility Curve?
(a) A fall in unemployment (b) Increase in age of retirement
(c) Technological improvement (d) Capital investment
(iii) Which of the following statements is NOT true?

(a) Ceteris paribus means other things remaining same
(b) One of the economic goals is to maintain price stability
(c) Normative aspect of economics deals with factual questions
(d) Agent is a decision maker within an economic model
(iv) Which of the following statements is correct?

(a) When the average cost is constant, the marginal cost must be falling
(b) When the average cost is rising, marginal cost is lower than average cost
(c) When the average cost is rising, marginal cost is higher than average cost
(d) When the average cost is falling, marginal cost must be rising
(v) Which of the following is NOT a feature of monopolistic competition?

(a) Low barriers to entry and exit
(b) Many firms supplying to the market
(c) Firms can change their actions without influencing the behaviour of other firms
(d) Each firm faces a horizontal demand curve
(vi) Which of the following may be regarded as a positive consequence of inflation?

(a) Improvement in the value of money (b) Benefit to the debtors
(c) Benefit to the creditors (d) Reduction in prices
(vii) Which of the following factors might cause an upward shift in the country’s
consumption function?
(a) A fall in share prices (b) A fall in interest rates
(c) Households deciding to be economical (d) Expectation of recession
(viii) Which of the following is NOT part of public expenditure?
(a) Investment by nationalised industries (b) Spending by local governments

(c) Capital spending of public companies (d) Interest on the national debt
(ix) Structural unemployment is a type of unemployment which:

(a) increases in a recession and falls in a boom
(b) arises due to lack of skills required for a newly created job
(c) arises when persons give up hope of finding a job
(d) occurs as a result of transition from one job to another
(x) By budgeting for a deficit, a government aims to reduce:

(a) consumer spending (b) inflation
(c) rate of economic growth (d) unemployment
(xi) Cheques are NOT money because they:
(a) are issued by the banks instead of the government

(b) are merely instructions to transfer money
(c) have value in exchange but little intrinsic value
(d) are not backed by either gold or silver
(xii) In an economy, there are Rs. 200 million in currency held outside banks,
Rs. 100 million in travellers’ cheques, Rs. 250 million in currency held inside the
banks, Rs. 300 million in checking deposits and Rs. 700 million in savings deposits.
The value of M1 (type of money) is:
(a) Rs. 750 million (b) Rs. 1,200 million
(c) Rs. 1,150 million (d) Rs. 600 million
(xiii) If a country has exports of goods of Rs. 5,300 million, exports of services of
Rs. 1,120 million, imports of goods of Rs. 5,700 million and imports of services of
Rs. 1,420 million, than the value of its balance of trade is:
(a) Rs. 700 million deficit (b) Rs. 400 million deficit
(c) Rs. 300 million deficit (d) Rs. 300 million surplus
(xiv) Which of the following statements is NOT true in context of Keynesian liquidity trap,
where prevailing interest rates are very low?
(a) People may decide to hoard cash
(b) Savings are moved to short-term investment bearing accounts
(c) Monetary policy triggers aggregate demand
(d) Forecast of return on investment is downgraded
(xv) Which of the following does NOT depict the concept of J curve?
(a) In short-run, the current account deficit gets worse before improving
(b) In short-run, import costs increase sharply
(c) In long-run, export revenues remain unchanged
(d) In long-run, high import prices have a contributory effect to inflation
Section B
Q.6 (a) Briefly describe any two methods used for measuring National Income. (04)
(b) What would be the multiplier effect of an increase in investment by Rs. 50 million on
the equilibrium level of income where marginal propensity to consume is 0.8 and the
proportion of additional income that is spent on imported goods is 30%? Illustrate
your answer with the help of a diagram. (06)
Q.7 (a) Explain how equilibrium of aggregate demand (AD) and aggregate supply (AS) may
be achieved under neo-classical approach. Use diagram to illustrate your answer. (07)
(b) What causes an upward or downward shift in the consumption function? Use diagram
stating two determinants of consumption function to support your answer. (03)
Q.8 (a) Describe any four unfavourable consequences of unemployment. (06)
(b) Briefly describe ‘Leading economic indicators’ and ‘Lagging economic indicators’.
Give two examples of each. (04)
Q.9 (a) State four main functions of taxation. (04)
(b) What do you understand by the terms ‘Expansionary fiscal policy’ and
‘Contractionary fiscal policy’? List two tools in respect of each of the above two
policies which the government may use for their implementation. (03)
(c) Explain two basic differences between public and private finance with reference to
‘Adjustment of income and expenditure’ and ‘Deficit financing’. (03)
Q.10 (a) What do you understand by the term credit money? Also describe three types of
credit. (06)
(b) State the matters which the government may consider while raising money from
capital markets. (04)
Q.11 (a) Briefly describe the four primary forces behind the determination of interest rate. (06)
(b) Explain the terms ‘Balance of trade’ and ‘Terms of trade’. (04)
Q.12 (a) Describe any four measures which the government may adopt to correct the balance
of payment position in Pakistan. (06)
(b) Briefly describe the following:

(i) Retail bank (ii) Specialized bank (iii) Mutual funds (04)
(THE END)
Suggested Answers
Certificate in Accounting and Finance – Spring 2020
Ans.1 (a) The features which distinguish a market operating in an environment of perfect
competition from a market which operates as a monopoly are:
(i) Number of sellers - In conditions of perfect competition there are a large number of
sellers in the market. The individual sellers compete to sell their products in the
market, but in a monopoly there is only a single firm which sells the product.
(ii) Entry and exit of firms- In perfect competition, new firms can freely enter the
industry and inefficient firms can exit if they suffer losses. Under conditions of
monopoly, there are several barriers which are difficult to overcome for prospective
new entrants.
(iii) Options available to buyers - In a market characterised by perfect competition, the

buyers have the option to purchase from any firm in the market. Under conditions of
monopoly, the buyers must purchase from the only seller who dominates the market.
(iv) Earning of normal and super-normal profits - In perfect competition, a firm may earn
super-normal profits in the short-run. In the long-run, the firm can earn only normal
profits as new firms would enter the market and force the prices to fall. Under
conditions of monopoly, a firm can earn super-normal profits in the short-run as well
as in long-run due to the existence of barriers which prevent entry of new firms.
(b) When price of a substitute good increases, the demand for the good that it is being
substituted for increases.
The following diagram shows how an increase in price of A affects equilibrium price and
equilibrium quantity of B:
Initially, equilibrium is at P0Q0. Increase in price of good A causes an increase in demand

for good B resulting in shifting of demand curve to right, from DD to D’D’. Consumers are
now willing to buy Qd quantity (point b) but producers are willing to sell only Q0 quantity
(point a). This shortage of supply over demand (Qd-Q0) causes an upward pressure on the
price. As the price rises, the excess demand falls because quantity demanded decreases
while quantity supplied increases. The supply curve intersects the new demand curve at
point c, so the new equilibrium price is P1 (up from P0) and the new equilibrium quantity is
Q1 (up from Q0).
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Ans.2 (a) (i) Allah is the sustainer: This describes the belief that Allah has created all the
resources available to man and is responsible for feeding and nourishing all the
creatures and human beings. Islam encourages people to do their best to earn a
livelihood using all lawful (Halal) and fair means whilst dissuading idleness.
(ii) Allah is the true owner of everything: Human beings are merely a trustee of resources
but have authority for using them but such authority is subject to certain guiding
principles that are required to be complied with.
(iii) State ownership: Islamic system neither proposes nor prohibits establishing state
owned enterprises. Therefore, a free market exists where entrepreneurs can profit
so long as they abide by the other rules of the Islamic economic system.
(iv) Practicing of moderation: Islam aims for a fair distribution of resources and so the
people are taught to share wealth where they can. In this regard, it proposes a
moderate life style and opposes extravagant as well as excessive misery.
(b) Division of labour:

Division of labour is the splitting of the production process into a number of individual
operations and making each operation the special task of one worker. It involves greater
levels of specialization among the workers.
Disadvantages:
(i) Loss of flexibility:
When workers specialize too much, it may be difficult for them to perform other
tasks in the event of changes in demand.
(ii) Monotony:
Since the workers perform the same task over and over again, they may get bored.
This could result in making mistakes, higher sickness rates and higher labour
turnover.
(iii) Loss of skills/Decline in craftsmanship:

By breaking the production process into a series of separate, simple and often
repetitive tasks, workers are not challenged. This could result in loss of interest in
acquiring new skills.
Ans.3 (a) Relatively Inelastic Demand:
Demand is relatively inelastic when the percent change in quantity demanded, i.e. area
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designated by B in the above diagram, is less than the percent change in price, i.e. area
designated by A in the above diagram.
In case of relatively inelastic demand, a decrease in price from OPo to OP1 would result in
increase in the quantity demanded from Oqo to Oq1.
(b) The failure or success of price cartels under oligopolistic market depends on following
factors:
(i) Control on supply:

For the successful price cartel, firms under oligopolistic market must hold all or
substantial market share.
(ii) Close substitutes:

Success of price cartel depends on non-availability of close substitutes of product
otherwise when higher price is set by oligopolists, the buyers will shift their demand
to close substitutes.
(iii) Price elasticity of demand:

Price cartel will be successful if price elasticity of demand for a product is inelastic.
Otherwise when oligopolists set higher price, buyers contract demand more
proportionately weakening the price cartel.
(iv) Agreement on individual share:

If all the firms in cartel agree on their allotted quota of supply, price cartels would be
successful. However, if firms secretly increase production and sale of the product,
price cartels would collapse because at increased supply, charging a higher agreed-
on price would not be possible.
Ans.4
The above diagram shows the concept of law of variable proportion and its various stages.
According to the law of variable proportion:

As the quantity of one variable input in a production process is increased, with quantities of other
inputs remaining fixed, marginal product first increases, then after reaching a maximum, it starts
decreasing and finally becomes negative.
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Three stages of the law:

Stage I:
In this stage, AP is maximum (R) whereas TP increases initially at increasing rate (L) and
thereafter it increases at diminishing rate (L to M). MP also increases initially and reaches its
maximum (N) however, later on it begins to diminish and becomes equal to AP (O). In this stage
MP exceeds or is equal to AP.
Stage II:
In this stage, TP continues to increase at diminishing rate and reaches its maximum point (G).
Correspondingly MP diminishes rapidly and becomes zero (C). AP starts from its maximum (R)
and thereafter it begins to decrease. In this stage, MP is less than AP.
Stage III:
In this stage, TP starts diminishing, AP also continues to decline and MP turns negative thus law
of variable proportions firmly manifests itself.
A rational producer will not opt to stop production at Stage I because his fixed factor will remain
underutilized and he will be foregoing the opportunity of increasing production by increasing the
quantity of the variable factor whose average product continues to rise throughout in Stage I. He
will also not choose Stage III where not only average product is falling but also the total product
is falling and marginal product is negative. He would opt to produce in Stage II, where the
marginal product continues to remain positive.
Ans.5 (i) (b) infinite

(ii) (a) A fall in unemployment
(iii) (c) Normative aspect of economics deals with factual questions
(iv) (c) When the average cost is rising, marginal cost is higher than average cost
(v) (d) Each firm faces a horizontal demand curve
(vi) (b) Benefit to the debtors
(vii) (b) A fall in interest rates
(viii) (c) Capital spending of public companies
(ix) (b) arises due to lack of skills required for a newly created job
(x) (d) unemployment
(xi) (b) are merely instructions to transfer money
(xii) (d) Rs. 600 million
(xiii) (b) Rs. 400 million deficit
(xiv) (c) Monetary policy triggers aggregate demand
(xv) (c) In long-run, export revenues remain unchanged
Ans.6 (a) (i) Expenditure approach:

This method arrives at national income by adding up all the expenditure incurred on
goods and services during the year.
(ii) Income approach:

This method measures the national income after it has been distributed and appears
as income earned or received by individuals of the country.
In this method, national income is calculated by adding up the rent of land, wages of
employees, interest on capital and profit earned by entrepreneurs/firms.
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(b) Multiplier effect:
In the above diagram, SS is the saving curve and II is the investment curve. These two
curves intersect at point E and hence, the equilibrium level of income is determined. If now
there is an increase in investment by Rs. 50 million, then II curve will shift upward to the
position of I’I’ and the two curves I’I’ and SS will intersect at point E’ which would be the
new equilibrium level of income. Hence, the diagram shows that an increase in investment
by Rs. 50 million would increase the national income by Rs. 100 million (1 ÷ (1-MPC +
MPM) × change in investment) i.e. 1÷(1-0.8+0.3). Thus the value of multiplier is equal
to 2.
Ans.7 (a) Equilibrium of AS and AD:

The equilibrium of aggregate supply (AS) and aggregate demand (AD) under neo-classical
approach is illustrated below:
In the above diagram, price level is measured on y-axis and real national output on x-axis.
AD is the aggregate demand curve whereas LRAS is the long run aggregate supply and
SRAS is the short run aggregate supply curves.
The macro economy is in equilibrium at the point where SRAS (value of output produced
within an economy) is equal to AD (level of demand for goods and services).
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The reason why equilibrium does not arise at the intersection of LRAS and AD is that LRAS
is the productive potential in the economy. Whereas SRAS is what is actually being
supplied in the macro economy, and is therefore what equilibrium should be based upon.
If the general price level is above the equilibrium point, then firms will persistently find
that their stocks remain unsold. This then indicates that they should cut back on further
production, to reduce the level of inventory.
If, however, the general price level is below the equilibrium point, then demand will
outstrip supply, stocks will quickly become run down, thus signaling to producers that they
should increase supply.
These mechanisms ensure that the macro economy is restored to equilibrium.
(b) Shifts in the consumption curve:

An increase or decrease in the level of consumption at each level of disposable personal
income respectively shifts the consumption function upward or downward.
In the following diagram, the consumption function has shifted upward. (C1 to C2). This
means consumers are spending a larger percentage of their income. This could be due to:
 positive forecasts about economic prospects increasing consumer confidence; or
 reduction in price level increasing consumers’ real wealth. (wealth effect)
Similarly, the consumption function may shift downward (C1 to C3) with the increase in
the price level (decrease in real wealth) or increase in consumer pessimism with regard to
future economic prospects. (decrease in consumer confidence).
Ans.8 (a) The unfavourable consequences of unemployment are:
(i) Loss of output – Unemployment results in the under-performance of the economy

and low levels of output of goods and services. Consequently, there is a decline in the
level of national income.
(ii) Loss of human capital – Unemployment leads to gradual erosion of the work skills of
the unemployed workers and deterioration in their capacity to perform satisfactorily
in future.
(iii) Increase in inequality in distribution of wealth – Unemployment results in loss of

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incomes and decline in savings of unemployed persons. This leads to more

inequitable distribution of wealth among the citizens.
(iv) Social costs – Unemployment brings social problems of mental depressions, increase
in crime rates and causes personal suffering to the unemployed workers and their
families.
(b) Leading economic indicators:

The nature of these indicators is that they are used to forecast at what stage the economy
will be in, at some time in the future.
These in particular give an indication for whether a peak or trough will be reached in the
following 3-12 months.
(i) Index of business confidence
(ii) Manufacturers’ new orders
Lagging economic indicators:

These indicators are used to assess whether an economy has reached a peak or trough 3-
12 months after it would have occurred.
(i) Consumer Price Index (i.e. level of inflation)
(ii) Average duration of unemployment
Ans.9 (a) Functions of taxation:

Following are the four main functions of taxation:
(i) Fiscal:
Taxes play their role in the formation of the budget necessary for the realization of
national and holistic government programmes. It funds the government
expenditures.
(ii) Allocation:
It acts as a means of distributing wealth among various groups of citizens: wealthy to
poor, as a means of maintaining a social stability.
(iii) Regulatory:
This function is aimed at achieving specific goals of the taxation policy through the
taxation mechanism.
(iv) Incentive:
It stipulates special taxation arrangements for certain members of society as a result
of past achievement. This function has a social facet.
(b) Expansionary fiscal policy:

A macroeconomic policy that seeks to increase the rate of economic growth.
Contractionary fiscal policy:

A macroeconomic policy that seeks to slow down the rate of economic growth.
List of tools which the government may use to implement expansionary or contractionary
fiscal policies.
Expansionary:
 Tax cuts
 Tax rebates
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 Increased government spending
Contractionary:
 Increase taxes
 Reduce subsidies
 Wage freeze
(c) Basic difference between public and private finance:

(i) Adjustment of income and expenditure:
An individual determines his expenditure according to his revenue and the
government adjusts its revenue to its expenditure.
For instance; while an individual knows his fixed income and spends his money
accordingly, the state first estimates the total expenditure and then imposes the taxes
accordingly.
(ii) Deficit financing:

In case of deficit financing, the government has an option to print currency notes and
create money to meet the expenditure.
On the other hand, individual cannot create money by printing currency notes or by
such other means.
Ans.10 (a) Credit money:

Any monetary claim against a physical or legal person that can be used for the purchase of
goods and services. For instance, IOU’s, bonds and money market accounts. Virtually any
form of financial instrument that is not repaid immediately is considered credit money
Types of credit:
Following are the kinds of credit which are classified according to the type of users:
(i) Trade credit/Commercial credit/Mercantile credit

This exists between a customer and a seller, usually in the commercial sector. A
purchaser can order a good, receive the good, and then pay for it after a certain
period of time. The credit terms will often mean that the amount has to be paid after
30, 60 or 90 days.
(ii) Bank credit

This type of credit exists when an individual or firm goes to a bank, receives an
amount of money upfront, and then pays back the amount over a period of time.
Bank credit can have varying terms of how much needs to be paid back, and by what
time.
(iii) Consumer credit/Retail credit

A consumer credit agreement often occurs between a retailer and a consumer. In
exchange for store credit (i.e. currency to spend at the establishment) a consumer
can pay the amount back over a certain period of time.
(b) Following are the matters which the government may consider while raising money from
capital markets:
(i) Rate of interest that needs to be paid to investors

(ii) Length of time to pay back
(iii) The risk factor of them not returning money to investors
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(iv) Alternative methods of raising capital (increasing taxes, etc.)
Ans.11 (a) Determinants of interest rate:
(i) Supply and demand

The interest rate depends upon the supply and demand of the credit. An increase in
demand would lead to an increase in the rate of interest whereas a decrease in
demand would lead to a decrease in the rate of interest.
On the contrary an increase in the supply of credit would decrease the rate of
Interest and a decrease in supply of credit would cause an increase in the rate of
interest.
(ii) Inflation rate

Interest rate rises with the rise in actual or expected inflation rate.
(iii) Government
The government has a say in the determination of the interest rates by way of
devising the monetary policy.
(iv) Type of loan

The interest rate on different type of loans depends on multiple factors, such as
credit risk, time, tax considerations etc. Risk refers to the likelihood of loan being
repaid. The higher the risk the more the return. Time is also an important factor. Long
term loans are riskier because of the time interval involved and the inflation, making
them more costly in terms of interest rates.
(b) Balance of trade

Balance of trade is a record of a country’s international trade transactions (import and
export of goods) with other countries during a given period of time. The Balance of trade is
in deficit when a country’s imports exceeds its exports and vice versa.
Terms of trade
The quantity of domestic goods that a country must give up to obtain a unit of imported
goods is called the terms of trade.
Ans.12 (a) Corrective measures for improving balance of payment position in Pakistan:
(i) Establishment of labour intensive industries:
Since labour is cheaper in Pakistan therefore labour intensive industries can be set
up and the products from such industries could be exported.
(ii) Export tariffs:

Reducing export duties will help us make our exports competitive in the
international market. Foreign countries would prefer to buy our products because of
reduced prices.
(iii) Joint ventures:

Establishing joint ventures with foreign investors can give a boost to our sales
outside the country.
(iv) Controlled imports:

Imports of all luxury items should be discouraged and only the needed items should
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be imported.
(b) (i) Retail bank: A bank targeted at the mass-market in which individual customers can
purchase/obtain mortgages, checking accounts, personal loans, and other bank
services.
(ii) Specialized bank: A bank targeted to a specific section of the economy in which firms
and customers can have access to specialized forms of banking services.
(iii) Mutual funds:

 Mutual funds are investment vehicles where many investors pool their
resources together to be invested in a variety of financial instruments.
 These are operated by professional money managers having specialist
knowledge of money markets and capital markets.
 These allow individual investors to diversify their investment which otherwise
might not be possible for investor with small amount of capital.
(THE END)
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Instructions to candidates:
Section A
Q.1 (a) Briefly explain why the production possibility curve is downward sloping and concave
to the origin. (03)
(b) What do you understand by the term ‘Market economy’? What are its main features?
Also state any four drawbacks of market economy. (05)
Q.2 (a) Describe the concept of long-run equilibrium of a firm under monopolistic
competition with the help of a diagram. (08)
(b) With the drop in price of smartphones from Rs. 80,000 to Rs. 70,000, the quantity
demanded by the consumers, in a particular market, increases from 20,000 phones to
30,000 phones per month. Calculate the elasticity of demand under percentage
method and identify the type of elasticity. (02)
Q.3 (a) What do you understand by ‘Reserve price’? Describe any six factors which may
influence the reserve price of a seller. (07)
(b) Show a graphical interaction of marginal cost, average variable cost, average fixed
cost and average total cost curves. (Explanation of the graph is not required) (02)
Q.4 Briefly describe the following diagram and the concept it depicts: (08)
(i) Which one of the following statements is NOT true for a planned economic system?
(a) Productive resources are state owned (b) Auto-adjusted price mechanism
(c) Full employment is possible (d) Less duplication of resources
(ii) A movie theatre may be regarded as an example of:

(a) public goods (b) private goods
(c) demerit goods (d) club goods
(iii) Which one of the following assumptions does NOT confer to the law of demand?
(a) There is no change in the income of consumers

(b) There is no substitute for the good
(c) The prices of related goods are unstable
(d) The size of population is stable
(iv) Which one of the following assumptions is related to the law of variable proportion?
(a) Continuous improvement in techniques of production
(b) All factors of production are proportionately varied
(c) There is no scarcity of the factors of production
(d) The factors are able to be combined to make a product
(v) Which one of the following is NOT a feature of perfect competition?

(a) Firms are price makers
(b) Perfect factor mobility
(c) Free entry and exit of firms in the market
(d) Products are homogenous
(vi) Which one of the following defines the economic growth rate?
(a) Increase in real investment (b) Increase in GDP
(c) Increase in real GDP (d) Increase in GDP deflator
(vii) Which one of the following statements is NOT true?
(a) High interest rates makes it less expensive to borrow

(b) Low interest rates discourage saving
(c) High interest rates would result in lower disposable income
(d) Low interest rates encourage consumption
(viii) A expansionary fiscal policy combined with a restrictive monetary policy would result
in:
(a) budget deficit to decrease (b) taxes to increase
(c) government expenditure to decrease (d) interest rates to increase
(ix) Which one of the following is NOT an outcome of the central bank’s expansionary
monetary policy?
(a) Increase of money supply in the economy
(b) Decrease in market rate of interest
(c) Increase in exchange rate
(d) Increase in aggregate demand
(x) Which one of the following is NOT part of the country’s current account?
(a) Export of goods (b) Foreign direct investment flows
(c) Unilateral transfers to other countries (d) Imports of services
(xi) Which one of the following is NOT a cause of cost push inflation?
(a) Increase in the price of raw material
(b) Fall in interest rates
(c) Increase in firm’s profit margins
(d) Exchange rate depreciation
(xii) What would be the velocity of circulation of money in an economy in which the
average price level is 1.8, real GDP is Rs. 260 billion and the nominal money supply is
Rs. 117 billion?
(a) 4.0 (b) 3.2 (c) 4.8 (d) 0.8
(xiii) The use of exchange control to overcome balance of payment deficit results in:
(a) decrease in imports (b) decrease in exports
(c) decrease in price level (d) decrease in national income
(xiv) Under which of the following circumstances, the value of the multiplier would be
higher?
(a) When both marginal propensity to consume and marginal propensity to import
are low
(b) When marginal propensity to consume is low and marginal propensity to import
is high
(c) When marginal propensity to consume is high and marginal propensity to
import is low
(d) When both marginal propensity to consume and marginal propensity to import
are high
(xv) Which one of the following will NOT be the result of devaluation of domestic
currency on the foreign exchange market?
(a) Export becomes less expensive in terms of foreign currency
(b) Imports become more expensive in terms of domestic currency
(c) Export volumes will increase
(d) Import volumes will increase
Section B
Q.6 (a) From the following data, compute GDP, GNP and NNP at market price:
Rs. in billion
Domestic consumption 290
Taxes on expenditures 76
Government expenditures 57
Capital formation 65
Exports 89
Imports 83
Subsidy 18
Net property income from abroad 11
Capital depreciation 25 (04)
(b) Describe three different types of Injections and Withdrawals from the Circular Flow
of Income. (06)
Q.7 (a) What is ‘Demand-pull inflation’? Briefly describe how fiscal and monetary stimulus
may cause demand-pull inflation. (05)
(b) Briefly describe any four determinants of savings. (05)
Q.8 (a) What do you understand by ‘Liquidity preference theory’? Describe the influence of
the motives identified by Keynes, on the liquidity preference of an individual. (07)
(b) Describe any three short-run factors which may affect marginal efficiency of capital
and investment. (03)
Q.9 (a) Describe any three benefits of economic growth. (03)
(b) The importance of public finance can be easily understood by its functions. Describe
any two main functions of public finance as emphasized by Musgraves. (04)
(c) Assume in a closed economy with no government intervention, Rs. 1 billion increase
in investment results in Rs. 5 billion increase in consumption. Compute the value of
marginal propensity to consume. (03)
Q.10 (a) Briefly describe any three tools which are available to the Central bank for controlling
money supply in an economy. (06)
(b) There are different types of financial instruments that can be classified as money. State
four types of money categorised by its liquidity. (04)
Q.11 (a) Describe the concept of ‘Deflationary gap’ with the help of a diagram. (04)
(b) Briefly describe the term ‘Derivatives’ and state the main objective of exchange traded
derivatives. (03)
(c) State three advantages and three disadvantages of direct taxation. (03)
Q.12 (a) What is ‘Balance of payment’? Describe any five causes due to which a country may
have a deficit in balance of payments. (07)
(b) Briefly describe the monetary measures which may be taken by the government to
correct balance of payments deficit. (03)
(THE END)
Suggested Answers
Ans.1 (a) Production Possibility Curve (PPC):

The PPC is downward sloping and concave to the origin because of the following reasons:
Downward sloping:
The reason for being downward sloping is that in order to increase the production of one
good, resources must be diverted from the other, hence decreasing the production of that
good. This happens due to scarcity of resources.
Concave to the origin:

The reason for being concave to the origin is because of increasing marginal rate of
transformation (MRT) or opportunity cost. some of the economy’s resources are better at
producing Good A, and some are better at producing Good B. Increasing MRT means more
and more unit of one good is to be sacrificed to get an additional unit of another good. This
change in the opportunity cost of producing each good, at various levels of production, is
what causes the curve to be concave.
(b) Market economy:

It is an economic system in which production and prices are determined by the free forces
of demand and supply that is unrestricted competition between privately owned business
instead of government. Government’s role is restricted to legislation, foreign affairs, peace
and security, and currency issuance.
Features:
Following are some of the main features of market economy:
 Reliance on the market and price mechanism to allocate resources
 Private ownership and control of factors of production
 Self-interest and profit motive motivate economic decisions
 Wages and other factor payments are set by the market.
Drawbacks:
Market economy has following drawbacks:
(i) Inequalities of income will lead to socially undesirable resource allocation
(ii) Ignores social costs of production and consumption decisions
(iii) Danger of emphasis on luxuries rather than necessities
(iv) Failure to plan long-term
Ans.2 (a)
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The above diagram depicts the concept of long run equilibrium of a firm under
monopolistic competition.
In the above diagram, AR = Average revenue curve, MR = Marginal revenue curve, LAC =
Long run average cost, LMC = Long run marginal cost.
In the long run the firms earns normal profit as new firms enter the industry and starts
production due to which supply increases and the price falls. The average revenue curve is
more elastic (i.e. flatter), since large number of substitutes are available in the long-run.
AR is tangent to the LAC at P. The equilibrium output in the long-run is OM and the
corresponding price is MP (=OP’). Therefore, at this point the firm is in equilibrium as both
average revenue and average cost is at MP and the firm is earning normal profits.
In the long-run, the following two conditions must hold. i.e.

Marginal Revenue = Marginal Cost and
Average Revenue = Average Cost
(b) Elasticity of demand: Percentage method

30,000 − 20,000 10,000
Percentage change in quantity demanded = ⇒ ⇒ 40%
(30,000 + 20,000) ÷ 2 25,000
70,000 – 80,000 – 10,000
Percentage change in price = ⇒ ⇒ – 13.33%
(70,000 + 80,000) ÷ 2 75,000
40%
Price elasticity (η) = ⇒ –3
– 13.33%
3 > 1, therefore demand is relatively elastic.
Ans.3 (a) Reserve price:

The price below which a seller refuses to sell his product is called the reserve price.
Factors which may influence the reserve price of a seller:
Following are some of the factors which may influence the reserve price of a seller:
 Future price: It depends upon the seller’s expectations regarding the future price. If he
expects a high future price, the reserve price will be higher and vice-versa.
 Future costs: If the costs are expected to fall, the reserve price will be lower and vice-
versa.
 Liquidity preference: The more urgent is the seller’s need for cash; the lower will be
the reserve price.
 Stock carrying cost/period: In case of higher carrying cost or longer carrying period
the reserve price would be lower.
 Nature of goods: If the goods are perishable, the seller cannot keep them for long
periods and consequently the reserve price will be low. Consequently, in case of
durable goods the reserve price will be high.
 Past costs: Although past costs are not relevant, yet, some obstinate seller’s attach too
much importance to costs incurred in the past and fix a high reserve price though it
may result in a greater loss.
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(b) Graphical representation of costs:
Ans.4
The above diagram depicts the concept of Law of Equi-Marginal Utility.
According to the law of Equi-Marginal Utility, a consumer maximizes his total utility with his
limited income when marginal utility of the last rupee spent on each commodity is equal. This is
achieved at marginal rate of substitution i.e. marginal utility of A divided by marginal utility of B
is equal to price of A divided by price of B.
In the above diagram, MN is the budget line representing the combination of two goods i.e. A and
B that the consumer can afford with limited income at his disposal. U, U 1 and U2 are various
indifference curves. An indifference curve that lies to the right of another represents a higher
value of satisfaction than the other. Therefore, U1 is attainable, but inefficient whereas U2 is
unattainable. The consumer maximizes his total utility at point O on an indifference curve which
is tangent to the budget line. Also, at point O, marginal utility per rupee spent on good A equals
the marginal utility per rupee spent on good B. At no other point could the consumer have a
higher utility given the constraints of the budget line.
Ans.5 (i) (b) Auto-adjusted price mechanism

(ii) (d) club goods
(iii) (c) The prices of related goods are unstable
(iv) (d) The factors are able to be combined to make a product
(v) (a) Firms are price makers
(vi) (c) Increase in real GDP
(vii) (a) High interest rates makes it less expensive to borrow
(viii) (d) Interest rates to increase
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(ix) (c) Increase in exchange rate

(x) (b) Foreign direct investment flows
(xi) (b) Fall in interest rates
(xii) (a) 4.0
(xiii) (a) Decrease in imports
(xiv) (c) When marginal propensity to consume is high and marginal propensity to import is
low
(xv) (d) Import volumes will increase
Ans.6 (a) (i) GDP at market price Rs. in billion

Domestic consumption 290
Government expenditures 57
Total expenditures 412
Add: Exports 89
Less: Imports (83)
418
(ii) GNP at market price

GDP at market price [As computed above] 418
Add: Net property income from abroad 11
429
(iii) NNP at market price

GNP at market price [computed above] 429
Less: Capital depreciation (25)
404
(b) INJECTIONS INTO THE CIRCULAR FLOW OF INCOME

Investments
Investments in capital goods are a form of spending on future output which is addition to
the expenditure and are therefore considered as injection of funds into the Circular Flow of
Income.
Government Spending
The funds spent by the government are injections in the Circular Flow of Income. The
funds may be raised by way of taxes or borrowings by the government.
Exports
The goods and services produced by the firms in the country and exported, result in
income from abroad and are therefore injections in the Circular Flow of Income.
WITHDRAWALS FROM THE CIRCULAR FLOW OF INCOME
Savings
Households do not spend all their income and save a certain portion. These savings are
withdrawals from the Circular Flow of Income.
Taxation
The amount of taxes paid to the government is not available for spending by the
households and is therefore considered as withdrawals from the Circular Flow of Income.
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Imports
The expenditures incurred on the purchase of imported goods and services accrue to firms
in foreign countries and therefore constitute withdrawals from a country’s Circular Flow of
Income.
Ans.7 (a) Demand-pull inflation:

- In demand-pull inflation, the aggregate demand for goods persistently exceeds their
supply. As the demand for goods is more than the total supply of goods at current price,
there is a tendency for increase in prices. Demand-pull inflation is generally observed in a
situation of full employment.
Fiscal and monetary stimulus causing demand-pull inflation.
Fiscal stimulus:
Fiscal stimulus will increase aggregate demand in the economy. Given the effects of
multiplier, an increase in government spending would result in greater increase in demand
which would lead to demand-pull inflation.
Monetary stimulus:
Monetary stimulus such as fall in interest rates, buying of government securities etc. would
trigger an increase in demand and may lead to a situation where ‘too much money chasing
too few goods’. The surplus demand would increase the price level and therefore, demand-
pull inflation.
(b) Determinants of savings:

(i) Level of income
Saving is determined by the level of income. There is a direct relation between the
two i.e., savings increase as the level of income increases.
(ii) Net wealth

A household’s net wealth is the value of all assets owned by a household, less any
liabilities or debt owed. A decrease in net wealth would make consumers less
inclined to spend and more inclined to save at each income level.
(iii) Interest rate

Interest is the reward for increasing savings by reducing consumption and the
amount paid by borrowers for current spending power. An increase in interest rate,
other things held constant, will lead to less spending and thus higher savings.
(iv) Objective and institutional factors

Factors such as political stability and security of property encourage people to save
more. Similarly, an established system of banks and other financial institutions
promotes savings by way of interest earning motives.
Ans.8 (a) Liquidity preference theory:

Liquidity preference theory states that all factors remaining the same, people prefer to hold
cash (liquidity) rather than assets that are illiquid. They will, however, be paid a premium
to hold more illiquid assets.
The three motives for holding money in liquid form are:
(i) Transactions motive:

Individuals need money to meet their day-to-day requirements of purchases of goods
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and services. The need to hold money for transactions arises because the payments
and receipts of individuals are not exactly synchronized. The liquidity preference or
transactions demand for money will increase either by an increase in the real
national income or an increase in the general price level or any combination of the
two.
(ii) Precautionary motive:

Individuals keep money in hand or with banks as a precautionary measure to meet
any unforeseen fluctuations in receipts and payments. The precautionary demand
for money arises due to uncertainty regarding the timing and size of payments and
receipts. The higher the level of national income, the larger amounts of money
balances that would be needed for precautionary purposes, reflecting higher liquidity
preference.
(iii) Speculative motive:

The holding of money has an opportunity cost in the form of income foregone by not
using the money to purchase an income bearing asset e.g. a bond. When interest rates
are high, individuals will hold lesser amounts for speculative purposes and therefore
have low liquidity preference. When the interest rates tend to be low, individuals will
retain large amounts in anticipation of increase in interest rates and would have high
liquidity preference.
(b) Factors that affect investment and MEC:

Short-run factors:
(i) Demand for product:
If demand for particular product is expected to grow, it would induce the firms to
make investment thereby, shifting MEC curve to the right.
(ii) The state of confidence:

If firms are optimistic about the favourable economic changes such as fall in costs,
they would expect the greater returns and be willing to make investments.
(iii) Liquid assets

If the assets an entrepreneur holds can easily be sold for cash then it may result in
more investment.
Ans.9 (a) Benefits of Economic Growth:

Following are benefits of economics growth:
(i) Higher Employment/lower unemployment
Real economic growth gives rise to higher employment. This is because with higher
levels of output, firms tend to employ more workers.
(ii) Increased tax revenues
Growth boosts the government finances by way of taxes that in turn help to reduce
the budget deficit.
(iii) Enterprise confidence
Sustained economic development casts a positive impact on company profits and
raises business confidence.
(b) Functions of public finance:

According to Musgraves, the major functions of public finance are the following:
(i) Allocative function
The allocative function refers to the role of government that it plays in providing
resources to extend support to the public goods. The examples include expenditure
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on infrastructure, national defence, etc.

The budgetary policy divides the total resources among private and social goods by
which the mix of social goods is chosen.
(ii) Distributive function
The government plays the distributive role by way of deciding as to whom the
resources should be allocated. Practically it means setting the balance between free
market outcomes and distribution through taxes and other means with a view to
reducing economic inequalities and yielding optimal income distribution.
(c) Computation of marginal propensity to consume:

The formula for the multiplier in a closed economy with no government is:
1 1 MPS = Marginal propensity to save
OR
MPS 1 − MPC MPC = marginal propensity to consume
From the above information the value of multiplier can be inferred as 5 (5÷1=5)
Therefore, the marginal propensity to save = 1÷5 = 0.2
As MPS + MPC = 1
Therefore MPC = 1 – 0.2 = 0.8
Ans.10 (a) The tools available to Central Bank to control money supply are as follows:
The reserve ratio A change in the reserve ratio changes the amount of reserves the banks
are required to keep with the central bank. Consequently the funds available for lending i.e.
money supply changes with the change in reserve ratio.
Open market operation When the central bank buys securities in the open market from
commercial banks or general public, the funds available with them will increase and vice
versa.
Discount rate it is the rate of interest which central bank charges on the loans it grants to
the commercial banks. The interest on such loans being discounted at the time the loan is
negotiated rather than collected at the time the loan is repaid.
A decline in the rate encourages commercial banks to borrow from the central bank,
thereby enhancing their ability to extend credit to the public and enhancing money supply.
The position is reversed when discount rate is increased.
(b) Types of money categorised by its liquidity:

Following are the types of money categorised by its liquidity:
 Transactional money (M0): it is used to buy and sell things within an economy
 Checking accounts (M1): money that is in peoples’ accounts that they have immediate
access to
 Savings deposits (M2): money that belongs to people, but which they cannot access
immediately
 Large time assets (M3): such as institutional money market funds
Ans.11 (a) When the equilibrium in the economy is at less than its production potential, there exists a
deflationary gap.
The deflationary gap can be explained with the help of following diagram:
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In the above diagram, short run aggregate supply is shown by the line SRAS and aggregate
demand by the line AD.
The actual level of national income is at the intersection of AD and SRAS i.e. at Ye whereas
Yf is the national income at full employment.
The gap between actual level of national income and national income at full employment
i.e. Ye and Yf is called a deflationary gap, as the price level is below of what it would be with
full employment in the economy.
(b) Derivatives:
Derivative is an instrument whose price is dependent on one or more underlying asset(s).
It is a contract between two parties. The price of a derivative changes with the change in
the underlying asset(s).
Objective of exchange traded derivatives (ETD):

The main objective of ETD is to reduce the level of counterparty risk, as trades are done by
means of regulated contracts through a clearing house.
(c) Advantages of direct taxation:

 Equitable: people with higher incomes pay more to the society than those with less
income, creating a more equitable distribution of (net) wealth.
 Cost of collection is low: it is an economical way of raising revenues, saving expense.
 Relative certainty: the government can estimate how much it will receive allowing
better planning of projects.
Disadvantages of direct taxation:

 Possible to evade: it is possible to falsify tax claims meaning the correct amount is not
always paid.
 Unpopular: the end user will often try to find ways to avoid paying it.
 Discourage savings/ investment: if too high, then it would leave consumers and firms
less money to put to other causes and larger investor would explore investment
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Ans.12 (a) Balance of payment:

The Balance of Payments is a systematic and complete record of a county’s transactions
with other countries which takes place over a period of time. The Balance of Payments is in
deficit when a country’s outflows are more than the inflows.
Causes of deficit in balance of payment:

Following are some of the causes of deficit in balance of payment:
(i) Natural factors

Natural calamities like drought or flood may easily cause disequilibrium in balance of
payments. These natural calamities can adversely affect agricultural and industrial
production. Exports may decline and imports may go up, causing a deficit in the
country’s balance of payment.
(ii) Trade cycles

Business fluctuations caused by the operation of trade cycles may also result in
deficit in country’s balance of payments. For instance, if there occurs a recession, it
may induce a fall in the exports and exchange earning of the country concerned
resulting in a deficit in the balance of payments.
(iii) Political instability

Political instability results in disrupting the productive potential within the country,
thereby causing a decline in exports.
(iv) Relatively high rate of inflation

High rate of inflation as compared to other countries makes the goods produced by
that country relatively expensive. As a result, its exports decline and the balance of
payment runs into a deficit.
(v) Trade restrictions by other countries

Sometimes other countries impose heavy custom duties or fix quotas or ban imports
from a country. It results in lower exports of that country.
(b) Monetary measures

Following measures may be taken by the government to correct balance of payments
deficit:
(i) Exchange rate depreciation
Reducing the rate of exchange of domestic currency in terms of foreign currency
would make the imports costlier and uncompetitive, whereas exports become more
competitive.
(ii) Deflation
A decline in the price level domestically may increase the attractiveness of domestic
goods on the international market, thereby increasing exports.
(iii) Exchange control

In an extreme situation, by restricting access to foreign exchange, the central bank
can control the level of imports.
(THE END)
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Section A
Q.1 (a) Briefly describe the following diagram and the concept which it reflects. (04)
(b) What is meant by ‘Costs of production’? Briefly describe implicit and explicit costs
and give two examples of each. (04)
Q.2 (a) What is an indifference curve? Briefly explain three main characteristics of
indifference curves. (06)
(b) Describe the concept of ‘change in supply’ with the help of a diagram. (05)
Q.3 (a) What do you understand by the laws of increasing returns and diminishing returns?
List four basic assumptions underlying the law of diminishing returns. (04)
(b) How does the law of increasing returns apply to the industrial sector? (03)
Q.4 (a) Mixed economy is a system in which free markets coexist with government
intervention. Explain the role of the government in a mixed economy. (06)
(b) What do you understand by the term ‘Goods’ as commonly used in economics?
Briefly describe ‘Public goods’ and give two examples of public goods. (03)
(i) The slope of a production possibility frontier is called:

(a) marginal rate of substitution (b) marginal utility of product
(c) marginal rate of transformation (d) marginal product
(ii) Following data has been provided to the Chief Executive Officer of a monopoly firm:
Marginal revenue Rs. 10 Marginal cost Rs. 11
Average revenue Rs. 16 Average cost Rs. 12
To maximise profit the firm should:
(a) reduce price and increase output
(b) reduce price and reduce output
(c) increase price and increase output
(d) increase price and reduce output
(iii) If the shape of an indifference curve is concave, it implies:

(a) diminishing marginal rate of substitution
(b) increasing marginal rate of substitution
(c) constant marginal rate of substitution
(d) none of these
(iv) A price floor set above the market equilibrium price is likely to cause:
(a) excess supply
(b) excess demand
(c) a decrease in price and a decrease in the quantity traded
(d) an increase in price and an increase in the quantity traded
(v) If cross elasticity of demand between Goods X and Y is negative then:

(a) the demand for both X and Y are price inelastic
(b) X and Y are complements
(c) X and Y are substitutes
(d) the demand for both X and Y are price elastic
(vi) Which of the following factors is NOT used in the multiplier formula?
(a) Marginal propensity to save (b) Marginal propensity to import
(c) Marginal propensity to tax (d) Marginal propensity to export
(vii) Crowding out is a result of:

(a) high government expenditure (b) low government expenditure
(c) high taxes (d) none of these
(viii) Which of the following is NOT part of a country’s Gross Domestic Product?
(a) Company profit (b) Net income from abroad
(c) Salaries of school teacher (d) Investment expenditure
(ix) Which of the following measures is likely to boost a country’s rate of economic
growth?
(a) Tax cuts (b) Reduction in tax rebates
(c) Reduction in subsidies (d) Decrease in government spending
(x) Which one of the following is most likely to lead to a rise in aggregate demand?
(a) Decrease in government expenditure (b) Decrease in income tax rate
(c) Increase in autonomous savings (d) Increase in rate of interest
(xi) If an excess demand for money exists in the economy, then as the money market
moves towards equilibrium, the short term interest rates are expected to:
(a) fall as treasury bill prices rise (b) fall as treasury bill prices fall
(c) rise as treasury bill prices rise (d) rise as treasury bill prices fall
(xii) A US resident sets up a factory in Pakistan. This transaction will be recorded in

Pakistan as:
(a) credit in current account (b) debit in current account
(c) credit in capital account (d) debit in capital account
(xiii) Which of the following is NOT a motive for holding money?

(a) Inflationary motive (b) Precautionary motive
(c) Transaction motive (d) Speculative motive
(xiv) A contractionary monetary policy in an open economy with a flexible exchange rate
would possibly steer the economy towards a:
(a) higher domestic interest rate and exchange rate appreciation
(b) higher domestic interest rate and exchange rate depreciation
(c) lower domestic interest rate and exchange rate appreciation
(d) lower domestic interest rate and exchange rate depreciation
(xv) Which of the following financial markets usually acts as an intermediary between
those looking to raise finance, and those looking to invest?
(a) Capital market
(b) Derivation market
(c) Money market
(d) Both (a) and (b)
Section B
Q.6 (a) Define ‘Average propensity to consume’ and ‘Marginal propensity to consume’. How
are these calculated? (04)
(b) Briefly describe ‘Autonomous investment and Induced investment’. Who may
undertake such investments? In respect of each of the above types of investment, draw
investment curve and give two examples. (06)
(Note: Explanation of the curves is not required)
Q.7 (a) What do you understand by ‘Consumer price index’ (CPI)? Also explain how it is
calculated. (04)
(b) Briefly describe four costs associated with high inflation. (06)
Q.8 (a) Describe four limitations of fiscal policy. (06)
(b) State two advantages and two disadvantages of indirect taxation. (04)
Q.9 (a) The problems of barter system led to the evolution of money in its current form.
Discuss how money resolved these problems. (03)
(b) State two advantages and two disadvantages of credit money. (04)
(c) Briefly describe the ‘Quantity theory of money’. (03)

Q.10 (a) Exchange rate may either be fixed or floating. State three advantages of each of these
types of exchange rates. (06)
(b) Briefly describe the components of a current account. (04)
Q.11 (a) What is meant by the term ‘Coincident economic indicators’ in the context of
assessment of a country’s economic stage in a business cycle? Also identify the
economic characteristics which are usually observed during recessionary periods. (05)
(b) State four types of difficulties which are usually associated with the measurement of
national income. (03)
(c) Compute the multiplier, if in an economy, out of every additional Rs. 100 of national
income, 8% is saved, 15% is paid in taxes and 17% is leaked from the economy in
imports. (02)
Q.12 (a) Briefly describe how the level of aggregate demand may reduce when a central bank
changes the reserve requirements for commercial banks. (05)
(b) What do you understand by the term ‘Inverse J curve’? Explain the concept with the
help of a diagram. (05)
(THE END)
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Ans.1 (a) The given diagram is of the kinked demand curve.
Theory of oligopoly suggests that once a price has been determined, it will not
change except to react to a competitor’s price change.
This means that members of a non-collusive oligopoly face a kinked (Bend) demand
curve as the reaction of competitors to a price change depends on whether price is
increased or decreased.
At the starting position the firm supplies Q0 at a price of P0.
Price increase
If the oligopolist raises price above P0 the rivals will maintain their price in order to
make the firm lose customers. Demand will move along the more elastic portion of
the demand curve to the left of Q0.
Price decrease
If the oligopolist cuts price below P0 then rivals will cut price too and hence there
will be little or no increase in demand. The firm will be forced on to the less elastic
portion of its demand curve to the right of Q0.
(b) Cost of production:

The overall costs incurred for producing a good or a service are called the costs of
production.
Explicit costs are the costs that have been incurred and have also been booked as an
expense. These are the expenses that are paid out costs and involve cash outflows
from the business.
Examples:
Examples include: salaries paid to the employees, prices of materials, overheads etc.
Implicit costs are the costs that have already been incurred but are not separately
shown as an expense while calculating the total cost of production.
Examples:
Examples include: salary of the entrepreneur, return on entrepreneur’s own
investment etc.
Ans.2 (a) Indifference curve:

An indifference curve shows the total satisfaction derived by a consumer from the
use of two commodities. It is drawn on the assumption that for all possible points
on an indifference curve, total satisfaction of the consumer remains the same.
Hence, the consumer is indifferent as to the combinations lying on an indifference
curve.
Characteristics of indifference curve:

Following are the characteristics of indifference curve:
(i) Negatively sloped

An indifference curve will slope from left to right. This is because if someone
increases consumption of one good, in order to maintain the same level of
satisfaction, he must decrease his consumption of the other.
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(ii) Higher indifference curve equals higher level of utility

An indifference curve that lies to the right of another represents a higher level
of satisfaction than the curve to the left.
(iii) Convex to the origin

In this instance, convexity means being bowed to the origin. The shape of the
curve has to do with how much of one good does a consumer want to
exchange for another in order to maintain the same level of utility. If the goods
are not perfect substitutes, it would be represented by indifference curves
which are convex to the origin.
(b) Change in supply:

When supply of a commodity changes due to change in non-price factor, it is said to
be a change in supply. It is represented by the shifting of supply curve from its
original place as shown in the following diagram:
Suppose SS is the supply curve before the change. S' S' shows a decrease in supply
because at the same price PM ( = P' M') less is offered for sale, i.e., OM' instead of
OM. S" S" shows an increase in supply because at the same price PM (= P" M") more
is offered for sale, i.e., OM" instead of OM.
Ans.3 (a) The law of increasing returns:

When a variable factor of production is applied while other factors remain constant,
there is a more than proportional increase in the output.
The law of diminishing returns:

If additional units of a variable input factor are added to a given quantity of fixed
input factors, a situation would be eventually reached in which each additional unit
of the variable factor would add less to the total output than the previous unit.
Assumptions underlying the law of diminishing returns:

Following are the four basic assumptions underlying the law of diminishing returns
(increasing cost):
(i) There is no change in the techniques of production or method of technology.
(ii) The law is applicable in the short run as the supply of one or other factor
cannot be increased within the short span of time.
(iii) All units of variable factors of production are assumed to be homogenous.
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(iv) The output is measured in physical units like tonnes, kilograms, etc.
(b) Application of the law of increasing returns to the industrial sector:

The increasing return mainly arises due to the fact that large scale production is
able to secure certain economies of scale, both internal and external.
These advantages may be on account of division of labour, specialized machinery,

commercial advantages of buying and selling wholesale, utilization of by-products,
use of extensive publicity and advertisement, availability of cheap credit, etc.
The law of increasing return operates as long as the plant is producing below
capacity. The increase in the marginal return continues till the plant begins to
produce its full capacity.
Ans.4 (a) In a mixed economy, government plays an important role to overcome the
inadequacies of free market economy. It includes:
(i) Distribution of income

To correct the unequal distribution of income and wealth that may exist
under free market system, government needs to reallocate income in an
economy. Quite often this involves raising taxes on high earners or luxury
items and spending them on providing facilities for general public.
(ii) Price control

To restrain the monopolies that may exploit consumers by charging
exorbitant prices under free market economy, government sometimes acts to
control prices for certain essential goods and services, either by becoming the
supplier for such commodities or imposing strict regulations on suppliers.
(iii) Production of merit goods

Government might introduce subsidies when there is a lack of incentive for
suppliers to produce the desired quantity of merit goods.
(iv) Framework of law

The government regulates and controls commercial activity to prevent
possible excesses or shortages that might occur in a completely free market
due to manipulation by influential traders and manufactures, etc.
(b) Goods:
In economics, goods refer to the products that satisfy human needs or wants and
provide utility.
Public goods:
A public good is a good whose benefits are social or collective.
Examples:
 national defense system
 highway network
Ans.5 (i) (c) marginal rate of transformation

(ii) (d) increase price and reduce output
(iii) (b) increasing marginal rate of substitution
(iv) (a) excess supply
(v) (b) X and Y are complements
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(vi) (d) Marginal propensity to export

(vii) (a) high government expenditure
(viii) (b) Net income from abroad
(ix) (a) Tax cuts
(x) (b) Decrease in income tax rate
(xi) (d) rise as treasury bill prices fall
(xii) (c) credit in capital account
(xiii) (a) Inflationary motive
(xiv) (a) higher domestic interest rate and exchange rate appreciation
(xv) (a) Capital market
Ans.6 (a) Average propensity to consume:

The average propensity to consume is a relationship between total consumption
and total income in a given time period. It is the ratio of aggregate consumption to
aggregate income.
Computation:
The formula for its computation is as under:
𝐶
𝐴𝑃𝐶 =
𝑌
Where, C stands for aggregate consumption and Y for aggregate income.
Marginal propensity to consume:

When income changes consumption also changes. Marginal propensity to consume
is the ratio of change in consumption to change in income.
Computation:
The formula for its computation is as under:
∆𝐶
𝑀𝑃𝐶 =
∆𝑌
Where, ∆𝐶 stands for change in consumption and ∆𝑌 for change in income.
(b) Autonomous investment:

Investment which is independent of the level of income or profits is called
autonomous investment.
Autonomous investment depends more on population growth and technical

progress than on anything else and is ordinarily undertaken by public bodies, or
private organisations not pursuing profit.
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Autonomous investment curve:
Examples:
 Construction of highways
 Street lighting
 Other infrastructure projects
Induced investment:
Investment which varies with change in national income is called induced
investment
This type of investment is usually undertaken by private enterprises in pursuit of

maximising profit. The greater the margin, the more will be invested until the
economic gains no longer outweigh the costs.
Induced investment curve:
Examples:
 Improvements to machinery
 Human capital (i.e. staff training that will generate an economic return)
 New assets
Ans.7 (a) CPI:

Consumer price index (CPI) is a measure of the weighted average of prices of a
basket of goods and services. It is calculated by taking price changes for each item
in the predetermined basket, averaging them, and weighing them based on the
importance of eachand then determining the weighted average. This average is
compared with the base year to compute the CPI.
(b) Costs of inflation:

Following are the costs associated with high inflation:
(i) Income redistribution:
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Higher inflation can have a regressive effect on lower income families.

Especially if the price of food and utilities increases drastically.
(ii) Fall in real incomes:

If wages are cut (to help tackle inflation) then this means that real incomes
have reduced.
(iii) Negative real interest rates:

If the savings interest rate is lower than inflation, than those who rely on
savings as their income will become poorer with the passage of time.
(iv) Cost of borrowing:

In response to high inflation, governments may increase the interest rates.
This will increase the cost of businesses getting a loan, which may stifle
investment.
Ans.8 (a) Limitations of fiscal policy:

Following are the limitations of fiscal policy:
(i) Forecasting
The fiscal policy is devised around predictions of various economic activities.
For the fiscal policy to work as desired, these predictions need to be
reasonably accurate. However, making reasonably accurate prediction is not
easy.
(ii) Time lag

Time lag means the difference between the time the action is taken and the
time when the fiscal measure has its impact felt.
(iii) Crowding out

Increased government spending for stimulating aggregate demand might
result in crowding out i.e. decreasing the size of private sector due to
increased government spending.
(iv) Tax
Raising taxes to reduce deficit reduces Aggregate Demand. Moreover, it may
cause demotivation to work. Consequently a fall in productivity might be
observed and Aggregate Supply may fall.
(b) Advantages of indirect taxation:
 Change the pattern of demand: the government can alter the demand for a
product say imported and luxury goods.
 Can correct externalities: if a product causes direct external costs (e.g. health
costs associated with alcohol or cigarettes), the tax can be used to lower
down the consumption.
Disadvantages of indirect taxation:

 Increases inequality: regardless of their incomes, people are faced with the
same tax on a good.
 Causes cost-push inflation: increases the price of inputs for goods.
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Ans.9 (a) Functions of money which resolved the problems of barter system:
Following are the four functions of money which resolved the problems of barter
system:
(i) To act as medium of exchange:

Barter system lacks the ability to exchange. Finding someone with opposite
needs is problematic in complex society. Money acts as a medium which is
acceptable to all.

Fixing a measure across different types of products was complicated under
barter system. Money acts as a unit of account allowing people to compare
the relative prices of goods and services through a common denomination.

Barter system lacks the ability to store value, particularly when goods are
perishable. Money acts as a store of value allowing people to forgo immediate
consumption if they have surplus resources, and to retrieve it later.
(iv) To act as a standard of deferred payment:

Barter system lacks the ability to allow people to consume the goods now and
pay for them in future. Money as a standard of deferred payment solved this
problem as it is easier to pay at a future date.
(b) Advantages and disadvantages of credit money:
Advantages of credit money:

 Allows immediate consumption of expensive goods, based on future earnings.
 Allows firms to invest, expand and generate future revenue, rather than use
internally generated funds.
Disadvantages of credit money:

 There is often an element of risk involved that the person issuing credit may
not receive full payment.
 It may lead to over spending.
(c) Quantity theory of money:

Quantity theory of money states that there is a direct relationship between changes
in the money supply and the rate of inflation. The theory is based on equation
MV=PT.
goods and services sold in the same period which is PT. The equation is useful as an
explanation of inflation when certain assumptions are made and which, if accepted,
means that the average price level (P) is solely determined by changes in the money
supply (M).
Ans.10 (a) Advantages of fixed exchange rate:

 Avoids damaging speculation effect against the local currency
 Promotes trade as importers and exporters are protected from exchange rate
risks
 Government has to pursue responsible economic policies domestically
because excess aggregate demand and inflation would make it very difficult
to support the currency in the long term.
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Advantages of floating exchange rate:

 The need for government intervention in the foreign exchange markets is
eliminated.
 It helps to correct balance of payments disequilibrium.
 Frees the policy instruments of government to concentrate on internal issues
such as unemployment and inflation.
 Variations in the rates of exchange act as a check against invasion of the
inflationary and deflationary forces.
(b) Components of current account:
(i) Trade in goods

This component includes import and export of tangible items such as finished
goods, semi-finished goods and component parts for assembly etc.
(ii) Trade in services
It includes intangible items such as tourism, financial services and
consultancy, etc.
(iii) Income
It refers to the overseas activity that leads to a flow of money back to the
country. For example, interest received from direct investment, the activities
of subsidiaries and dividends earned from owning shares in foreign firms, etc.
(iv) Unilateral transfers

It includes receipts and payments that take place without anything receiving
in return. For example, donations, personal remittances, aid and grants, etc.
Ans.11 (a) Coincident economic indicators:

These indicators are events and measures that indicate a peak or trough. These
include:
 Number of people in employment
 Industrial production
 Personal incomes
 Size of manufacturing and trade
The economic characteristics which are most commonly observed during a

recessionary period are:
(i) decline in demand for labour followed by layoffs and increase in
unemployment rates.
(ii) fall in demand for capital goods, consumer durable goods and luxury items
and downward trend in their prices.
(iii) sharp drop in business profits.
(iv) decline in volume of shares traded on the stock exchanges and fall in their
prices.
(v) decline in the demand for credit accompanied by drop in interest rates.
(b) Difficulties faced in measuring national income:

(i) Non-monetized transactions such as services of housewives and agricultural
products used by farmers for own consumption are generally not considered
while measuring the national income.
(ii) The barter transactions may either be totally ignored or included on the basis
of approximation.
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(iii) Income of foreign firms creates complications i.e. whether to include it in

national income of the country of operation or country of origin.
(iv) Collection, compilation and analysis of statistical data is a highly technical and
difficult exercise and availability of sufficient trained staff is often difficult.
(c) Computation of multiplier:
Calculation of the value of multiplier:
Multiplier = 1 ÷ (sum of the propensities to save + tax + import)
= 1÷ (0.08+0.15+0.17) = 1÷0.4 = 2.5
Ans.12 (a) The central banks are able to reduce the level of aggregate demand in an economy
by changing the reserve requirements, as described hereunder:
(i) When a central bank increases the level of reserves that the commercial
banks must hold, the commercial banks have to reduce the level of loans that
they give out. A certain reduction in the level of reserves that commercial
banks must hold translates, through the multiplier effect, in a much bigger
contraction in the overall money that they loan out. This causes the money
supply to decline.
(ii) As the money supply contracts, money becomes “tight” (i.e. less available and
more expensive). This reduced level of money in the economy raises the
interest rate, and reduces the amount of credit available in the economy.
Consequently interest rates rise and firms/individuals looking for investment
are discouraged from borrowing, and spending more money.
(iii) As a result of the above aggregate demand reduces.
(b) Inverse J curve:
The opposite of J-curve concept is inverse J-curve, where countries attempt to

rebalance a current account surplus by appreciating exchange rate.
The inverse J-curve shows how in the short run, the surplus may further increase
before decreasing. This concept is depicted below:
The inverse J curve effect is observed in trade balances because the stronger
currency initially translates into more cheaper imports and costlier exports, leading
to a bigger initial trade surplus.
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However, in long-run, because the affected country’s exports are now expensive in
currency terms, they start to fall as foreign demand for the high-priced option
decreases. Local consumers also purchase fewer of the locally produced expensive
goods and substitute them with comparable imported goods which have now
become more affordable. As a result, the trade balance eventually deteriorates and
the surplus decreases to a lower level than it was at before the exchange rate
appreciated.
The lag is caused by the fact that importers and exporters have to honor pre-existing
contracts, so the trade volumes initially remain unchanged even though the
exchange rate and relative prices have changed.
Therefore, in the above diagram, starting from Point B, the surplus first increases in
the short-run and goes down into a deficit as time goes on.
(THE END)
Page 10 of 10

Section A
Q.1 (a) The basic economic problem is the scarcity of resources and the multiplicity of ends.
Discuss how following participants in an economy make decisions to deal with that
problem:
(i) households (ii) firms
(iii) government in market economy (iv) government in mixed economy (06)
(b)
From the above diagram of Production Possibility Frontier, describe what the
following points/curve depict:
(i) point G (ii) point H (iii) curve XY (03)
Q.2 Consider the following schedule that pertains to the product of a firm engaged in the
manufacture and sale of consumer products:
Price (Rs.) 150 120

Quantity demanded (Units) 20 24
From the above schedule:

(a) determine the price elasticity of demand using expenditure method and percentage
method. (04)
(b) recommend the course of action the firm may adopt along with appropriate
justification. (02)
Q.3 (a) What do you understand by ‘Consumer equilibrium’? (02)

(b) In the study of consumer equilibrium, price effect is the aggregate of substitution effect
and income effect. Explain it with the help of a diagram assuming that:
goods are normal and substitute of each other.
price of one good changes whereas consumer income and price of the other good
remain constant. (08)
Q.4 (a) Explain the concept of economies and diseconomies of scale with the help of long run
average cost curve. Also mention two factors that lead to economies and diseconomies
of scale. (07)
(b) One of the characteristics of a monopolist is the ability to engage in price

discrimination. Mention any three conditions required for price discrimination. (03)
(i) In deciding what products to produce, the central planners in a planned economy
would give least priority to:
(a) size of economy’s labour force
(b) production capabilities of the economy’s factories
(c) consumer preferences
(d) type of raw materials produced by the economy
(ii) Which of the following would most likely result in failure of price cartel under
oligopoly?
(a) Non-availability of close substitutes
(b) Existence of control over supply
(c) Price elasticity of demand is elastic
(d) Presence of agreement on allotted quota of supply
(iii) The supply curve would shift to the left when:

(a) price of good goes down
(b) taxes of government go down
(c) prices of substitute goods go down
(d) prices of complements go down
(iv) A consumer with fixed income at his disposal would maximize his utility at a point
where:
(a) marginal utility per rupee from each good is same
(b) marginal utility from each good is same
(c) marginal utility from each good is maximized
(d) marginal utility per rupee from each good is maximized
(v) Which of the following is not an advantage of floating exchange rate?

(a) It minimizes government intervention in foreign exchange markets
(b) It automatically corrects disequilibrium in balance of payments
(c) It stimulates demand for exports
(d) It frees policy instruments of government
(vi) Which of the following best describes Keynesian Liquidity trap?

(a) High interest rates, low savings rates (b) Low interest rates, high savings rates
(c) High interest rates, high savings rates (d) Low interest rates, low savings rates
(vii) The imposition of indirect taxes would likely result in:

(a) demand-pull inflation (b) cost-push inflation
(c) wage spiral inflation (d) deflation
(viii) When the national income is in equilibrium, an increase in investment causes the
equilibrium to change. Which change of equivalent value would bring national income
to its original equilibrium level?
(a) Decrease in government spending (b) Increase in government spending
(c) Decrease in government taxes (d) Increase in exports
(ix) A central bank is likely to increase interest rates when economy is in a phase of:
(a) prosperity (b) downturn (c) recession (d) trough
(x) For reducing inflationary pressure, the most appropriate combination of policies for a
central bank would be:
(a) increase reserve requirement, reduce discount rate and sell government securities
(b) increase reserve requirement, increase discount rate and sell government
securities
(c) increase reserve requirement, reduce discount rate and buy government securities
(d) increase reserve requirement, increase discount rate and buy government
securities
(xi) Given below is the Consumer Price Index (CPI) of a country for four years:
Year 2014 2015 2016 2017
CPI 500 550 600 650
Based on the above schedule, which of the following statements is correct?
(a) The rate of inflation has been consistently rising from 2015 to 2017
(b) The rate of inflation in 2016 is 10%
(c) The rate of inflation is the highest in 2017
(d) The rate of inflation has been consistently falling from 2015 to 2017
(xii) The expectation of fall in prices would result in:
(a) shift of current consumption curve to the left
(b) shift of current consumption curve to the right
(c) no change on current consumption curve
(d) shift of current savings curve to the left
(xiii) A firm is operating in an industry where many firms are producing similar products.
Each firm is able to set prices of its products without affecting the market place as a
whole. The firm is most likely operating in:
(a) monopoly (b) oligopoly
(c) perfect competition (d) monopolistic competition
(xiv) Which of the following statements is correct regarding instruments of financial
market?
(a) Derivatives are equity instruments traded on money market
(b) Certificate of deposits are subject to higher default risk than treasury bill
(c) Debentures are short term money market instruments
(xv) The basic concept which underlies the accelerator theory of investment is:
(a) investment depends on the level of savings
(b) investment is inversely related to the rate of interest
(c) investment is determined by the volume of commercial bank lending
(d) investment in an economy is a function of output
Section B
Q.6 (a) What do you understand by ‘Marginal efficiency of capital (MEC)’? Explain the
relationship between rate of interest and the level of investment with reference to MEC
(b) Explain the impact of decrease in interest rates on firms and individuals. (02)
Q.7 (a) Sometimes the governments weaken the domestic currency deliberately with the
objective of reducing balance of payments deficits by making imports more expensive
and exports less expensive. Describe the factors upon which the effectiveness of such
policy depends. (05)
(b) Why do governments interfere to influence the foreign exchange rates? List the policy
instruments available to a government to influence the foreign exchange rates. (05)
Q.8 (a) Explain four main canons of taxation as suggested by Adam Smith that are usually
considered by a government while designing the tax system of the country. (08)
(b) There is a series of events that occur throughout the business cycle but there are certain
indicators that can be identified and used to assess at what stage the economy is in.
List any two such indicators under the headings of:
(i) Leading economic indicators (ii) Lagging economic indicators (02)
Q.9 (a) Discuss the non-monetary corrective measures which a country may take to overcome
its current account deficit. (04)
(b) From the following data, compute the overall balance of payments of the country duly
segregated between current and capital accounts:
Net balance
Balance of payment item
(in billion)
Investment income (15)
Portfolio investment flows 10
Overseas transfers 25
Trade in goods (75)
Short-term banking flows (5)
Foreign direct investment flows 20
Trade in services 20
Changes to reserves of gold / foreign currency 15 (06)
Q.10 Monetary policy can play a vital role in influencing the use of money and credit within an
economy in order to achieve certain objectives.
Briefly discuss:
(a) objectives of monetary policy and how these objectives can be achieved. (05)
(b) limitations of credit creation in achieving economic objectives. (05)
Q.11 (a) The economy is in equilibrium at the point where short run aggregate supply (value of
output produced within an economy) is equal to aggregate demand (level of demand
for goods and services). Explain the equilibrium of economy with the help of a diagram
where a government has increased its spending and there is a rise in wage rates. (07)
(b) List any three factors that may cause a shift in:
(i) aggregate demand curve (ii) short-run aggregate supply curve (03)
Q.12 (a) From the following data, compute Gross National Product (GNP) at market price and
at factor cost:
Rs. in billion
Consumers’ expenditures 450
Taxes on expenditures 175
Government spending 120
Exports receipts 50
Imports payments 110
Subsidy 15
Capital depreciation 40 (05)
(b) Briefly discuss the main features of:
(i) mutual funds (ii) derivatives (05)
(THE END)
Suggested Answers
Note:
The suggested answers are provided for the guidance of the students. However, there are alternative
solution(s) to the questions which are also considered by the Examination Department while marking
the answer scripts.
Ans.1 (a) (i) Households

These are individuals having limited income at disposal. They attempt to allocate
scarce income between goods and services to attain maximum satisfaction.
(ii) Firms
These are businesses/organizations having limited factors of production (land, labor,
capital and enterprise). They attempt to allocate scarce factors of production between
potential products and services where profit is maximized.
(iii) Government in market economy

Governments in market economy has low or no interference in the allocation of
resources. It relies on the market and price mechanism for allocation of resources by
allowing freedom to other economic participants to decide.
(iv) Government in mixed economy

In mixed economy, only some very critical decisions are taken by the government
with regard to allocation of resources for the purpose of ensuring minimum or
maximum supply of goods and services.
(b) (i) Point G

This point depicts a situation where resources are not being fully utilized.
(ii) Point H
This point depicts that given the production capacity of an economy, it is not
attainable.
(iii) Curve XY
It depicts all possible combinations of two alternative goods that an economy can
produce with the resources available to it.
Ans.2 (a) Expenditure method

Revenue = Price × Quantity demanded (qd)
At Rs. 150
Revenue = 150 × 20
= Rs. 3,000
At Rs. 120
Revenue = 120 × 24
= Rs. 2,880
The decline in price resulting in less increase in QD resulting in total revenue decreasing,
therefore PED is inelastic i.e. less than unity.
Percentage method
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(b) Recommendation
Since the price elasticity of demand for the firm’s goods is inelastic (less than unity), the
firm should seek either to increase the price or maintain it because the reduction in price
would result in reduced revenue.
Ans.3 (a) The consumer is said to be in equilibrium when maximum possible satisfaction is obtained
from the individual’s purchases / when budget line and indifference curve are tangent, at
the prices prevailing in the market and given the amount of money the individual possesses
for making purchases.
(b)
The initial equilibrium of the consumer is at E where indifference curve (IC1) is tangent to
budget line AB. The fall in price of good X (assuming consumer income and price of Y
remain constant) would result in new equilibrium at E' as consumer would buy more of
good X and less of good Y. This price effect is an aggregate of income effect and
substitution effect.
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The change in price would result in increase in real income of consumer. To determine the
substitution effect, the effect of increase in real income is eliminated so that consumer
remains at original indifference curve (IC1). To achieve this, a dotted line CD parallel to
budget line AB1 is drawn. The new budget line is tangent to IC1 at E''.
E to E'' represents the substitution effect and E'' to E' represents income effect. E to E'
represents the price effect which is the aggregate of substitution effect and the income effect.
Ans.4 (a)
It can be seen from the above diagram that initially as the output of the firm increases, the
unit cost declines i.e. firm is achieving economies of scale due to large scale of production
and long run average cost curve goes down.
After certain level of output is reached, average cost curve remains constant. This point is
called minimum efficient scale as unit costs are minimized because of maximization of
economies of scale. In the above diagram, this level of output is Qmes.
Any further increase in production level results in rising unit costs due to inefficiencies
generated by diseconomies of scale which in the above diagram is depicted by the rise in
long-run average cost curve.
Factors that lead to economies of scale include:
 Trading – ability to buy in bulk quantities at more optimal prices.

 Financial – larger firms are in a better position of borrowing at favorable terms
 Technical – better efficiency through larger quantities of output
 Managerial – ability to employ specialist managers to increase efficiencies
 External – development of specialized labor force when firms cluster together
Factors that lead to diseconomies of scale:
 Control – too big firm may be difficult to manage and management may lose control
 Local/firm’s infrastructure – there might be strains on local/firm’s infrastructure as
the scale of activities increases.
(b) Three conditions that are required for price discrimination:

 Firm must have monopoly power in terms of setting prices.
 Each group of buyers must have a different elasticity of demand so that consumer
surplus can be extracted.
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 Market is divided into sub-markets and each such sub-market is absolutely separate
i.e. it should not be possible to freely transfer units of the commodity from one sub-
market to another.
 It should not be possible for the buyers in the dearer market to freely sneak into the
cheaper market to take advantage of the low price.
Ans.5 (i) (c) consumer preferences

(ii) (c) Price elasticity of demand is elastic
(iii) (d) prices of complements go down
(iv) (a) marginal utility per rupee from each good is same
(v) (c) It stimulates demand for exports
(vi) (b) Low interest rates, high savings rates
(vii) (b) cost-push inflation
(viii) (a) Decrease in government spending
(ix) (a) prosperity
(x) (b) increase reserve requirement, increase discount rate and sell government securities
(xi) (d) The rate of inflation has been consistently falling from 2015 to 2017
(xii) (b) shift of current consumption curve to the right
(xiii) (d) monopolistic competition
(xiv) (b) Certificates of deposits are subject to higher default risk than treasury bill
(xv) (d) investment in an economy is a function of output
Ans.6 (a) MEC can be explained as the rate of discount that would make the present value of the
prospective yields from the capital asset equal to its supply price.
There is an inverse relationship between the rate of interest and the level of investment i.e.
higher the rate of interest, lower the level of investment and vice versa. This relationship in
terms of MEC, can be explained with the help of following diagram:
In the above diagram, MEC curve represents the level of investment that will take place in
the economy at various levels of interest rate. At interest rate ro, investment Io is
marginally efficient i.e. has a net present value of 0 (or its internal rate of return equals rate
of interest). All points to the left of the MEC have a positive net present value. If the
interest rate falls to r1, then further investment would become feasible up to total
investment I1 which is now marginally efficient.
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(b) A decrease in interest rate would impact firms and individuals as follows:
 Firms would be encouraged to invest more as it would be easier for firms to earn an
adequate return on project since cost of investment has reduced.
 Individuals would be discouraged to save more as their savings would give low return
and they would likely incline towards more consumption.
Ans.7 (a) The effectiveness of policy of devaluing the domestic currency depends on:
 Price elasticity of demand for imports

If price elasticity of demand for imports is inelastic, then making imports more
expensive will not significantly reduce the volume of demand for imported goods and
services. It will more likely increase total expenditure on imports thus further
deepening the balance of payments deficit thus making such policy ineffective.
 Price elasticity of demand for exports

If price elasticity of demand for exports is inelastic, then making exports less
expensive will not significantly increase the volume of demand for exported goods
and services. It will more likely reduce total revenue from exports thus further
deepening the balance of payments deficit thus making such policy ineffective.
(b) Governments often interfere to influence the foreign exchange rates because of the
following reasons:
(i) To stabilize the currency against the pressures of short-term speculations.
(ii) To stimulate demand for exports or to reduce imports.
Policy instruments available to government to influence foreign exchange rates:

(i) Setting of domestic interest rate.
(ii) Central bank’s intervention in purchasing or selling of currency.
(iii) Structural adjustments to the behavior of the economy.
Ans.8 (a) Four main canons of taxation as suggested by Adam Smith are explained below:
(i) Canon of Equality:

According to canon of equality, tax should be paid in proportion to the ability of the
tax payer i.e. the amount of revenue generated by (income of) tax payer. This requires
progressive taxation where tax payers have to pay higher rate of tax as their income
increases.
(ii) Canon of Certainty:

According to this canon, there should be no ambiguity as to the timing, manner and
amount of tax payment expected from tax payer. Tax budgets are given publicity and
transparency to make the tax payers aware of as to why and when they are expected
to pay a particular sum.
(iii) Canon of Convenience:

According to this canon, time and manner of tax payment should be convenient for
the tax payers. For example, consumers paying taxes at the time of purchase of goods
or services or tax being deducted at the time of payment of salaries.
(iv) Canon of Economy:

According to this canon, tax should be economical in terms of its collection. Tax
policies should be as such to ensure maximum tax is collected and in the most
economical manner.
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(b) (i) Leading economic indicators:

 index of business confidence
 manufacturers’ orders
 building permits for private housing
 money supply
(ii) Lagging economic indicators:

 consumer price index (i.e. level of inflation)
 average duration of unemployment
 interest rates
 average income
Ans.9 (a) A country may take any or combination of following non-monetary measures to overcome
current account deficit:
(i) Increasing import duties by means of tariff thereby, making the imports expensive.
(ii) Fixing the quantity of goods that may be imported by means of quotas to restrict the level
of imports.
(iii) Helping exporters to promote locally manufactured goods in international market by
organizing exhibitions, trade fairs and striking diplomatic deals.
(iv) Encouraging manufacturing and consumption of locally produced goods and services /
import substitution by means of providing specialist training, subsidies and tax reliefs.
(b) Computation of the overall balance of payments of the country:

Net balance
Balance of payment item
(in billion)
Current account
Trade in goods (75)
Trade in services 20
Investment income (15)
Overseas transfers 25
Current account balance (45)
Capital account
Foreign direct investment flows 20
Portfolio investment flows 10
Short-term banking flows (5)
Changes to reserves of gold / foreign currency 15
Capital account balance 40
Net errors and omissions 5
Overall balance of payments 0
Ans.10 (a) Objectives of monetary policy and the means to attain them:
(i) Price stability to keep the inflation low by managing the supply of money.
(ii) Economic growth by encouraging consumption and investments.
(iii) Exchange rate stability by effective utilization of policy instruments.
(iv) Full employment by encouraging consumption and investments by allowing resources
to be fully utilized.
(v) Credit control by regulating commercial banks through central bank (discount rate
policy, reserve requirements, open market operations, etc.).
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(b) Limitations of credit creation in achieving economic objectives:
(i) The initial size of money supply. If initial size of money supply is lower, less credit
would be created and vice versa.
(ii) Liquidity preference of people. In period of high inflation, people may not wish to
hold their money in banks that would mean less money is available to banks thereby
less credit would be created.
(iii) Availability of quality securities. If high valued collateral assets are not available, less
credit would be created and vice versa.
(iv) Economic conditions of trade and business. In the period of depression, investors
would be less inclined to borrow thereby limiting the role of credit creation.
Ans.11 (a) Illustration:
The existing equilibrium is at point A. An increase in government spending would shift the
aggregate demand curve outwards (i.e. from AD1 to AD2) and now the equilibrium is
determined at point B. However, rise in wage rates would shift the short-run aggregate
supply curve inwards (i.e. from SRAS1 to SRAS2) and the new equilibrium is determined
at point C which would mean that increase in government spending has been cancelled out
by increase in wage rates and output level returns to the same level as before.
(b) (i) Aggregate demand curve

– Change in consumer income
– Change in government spending
– Imports or exports becoming more or less attractive
– Change in firms’ expectations of economy
(ii) Short-run aggregate supply curve

– Change in factor productivity (labor and capital)
– Change in size and quality of capital stock
– Change in size and quality of labor force
– Change in unit cost of labor
– Change in producer taxes or subsidies
– Change in inflationary expectations
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Ans.12 (a) GNP at market price:

Rs. in billion
Consumers’ expenditures 450
Government spending 120
Total expenditures 710
Add: Exports receipts 50
Less: Imports payments (110)
GDP at market price 650
GNP at market price 660
GNP at factor cost:

Rs. in billion
GNP at market price 660
Less: Taxes on expenditures (175)
Add: Subsidy 15
GNP at factor cost 500
(b) Mutual Funds

 Mutual funds are investment vehicles where many investors pool their resources
together to be invested in a variety of financial instruments.
 These are operated by professional money managers having specialist knowledge of
money markets and capital markets.
 These allow individual investors to diversify their investment which otherwise might
not be possible for an investor with small amount of capital.
Derivatives
 Derivative is merely a contract between two parties.
 Its price is dependent on one or more underlying asset(s).
 They are traded over the counter (OTC) and/or on an exchange.
(THE END)
Page 8 of 8

Section A
Q.1 (a) What do you understand by the term ‘Capital formation’? Briefly describe the stages
involved in the process of capital formation. (04)
(b) Following data relates to a country Ruritania which is capable of producing the
following combinations of consumer goods and capital goods with a given quantity of
resources and technology:
Consumer goods 140 120 100 70 0

Capital goods 0 60 80 100 120
Required:
(i) With the help of above data, draw a production possibility curve. (03)
(ii) Ruritania, after full utilization of its resources, is currently producing 70 units of
consumer goods. What would be the opportunity cost to Ruritania in terms of
capital goods if it decides to produce 50 more units of consumer goods? (01)
Q.2 (a) Define the law of ‘Equi-marginal utility’ and list the assumptions underlying the law.
Also describe any two limitations of the law of equi-marginal utility. (07)
(b) List the factors which determine the price elasticity of demand of a commodity. Briefly
describe what characteristics of a commodity are indicated by a negative or a positive
sign of ‘Income elasticity of demand’ and ‘Cross price elasticity of demand’ of that
commodity. (06)
Q.3 Describe the following diagram and the concept which it depicts. (06)
Q.4 (a) Briefly describe why the short-run average cost curve is U shaped. (05)
(b) Describe the law of variable proportion. Also state the assumptions on which the law of
variable proportion is based. (03)
(i) The mode of Islamic financing where a financial expert offers services for managing
investment; and the investor and the expert share profits, is called:
(a) Ijara (b) Mudaraba (c) Musharaka (d) Murabaha
(ii) Which of the following statements relate to normative aspect of economics?

(a) Government should provide basic health care to all citizens
(b) Government-provided health care increases public expenditures
(c) Economists are paid more than the accountants
(d) Technology has great impact on productivity
(iii) If the demand equation for a good is Qd = 20 – P and the supply equation is
Qs = 6 + 1.5 P and the price is set equal to 2.4 above the equilibrium level, there will be
an excess:
(a) demand of 6 units (b) supply of 6 units
(c) demand of 12 units (d) supply of 18 units
(iv) The price of a product is Rs. 3 and the quantity supplied is 10 units. When price is
increased to Rs. 7 the quantity supplied increases to 12 units. The supply is:
(a) perfectly elastic (b) elastic
(c) inelastic (d) perfectly inelastic
(v) Which of the following may NOT be regarded as strength of a collusive oligopoly?
(a) production techniques and costs of all the firms are similar
(b) there are no barriers on entry of new firms
(c) similar products are produced by the firms
(d) the market is stable
(vi) Assume that marginal propensity to consume out of disposable income is 0.8 and the
rate of tax is 30% of total income. Under the simple Keynesian model, what would be
the total change in national income if government increases public spending by Rs. 150
million?
(a) Rs. 187.5 million (b) Rs. 341 million (c) Rs. 525 million (d) Rs. 750 million
(vii) Assume that in 2017 the nominal gross domestic product of a country is Rs. 500 billion
and the price index is 200. If the price index was 150 in 2010 what would be the real
gross domestic product of the country in 2017 computed in terms of 2010 prices?
(a) Rs. 125 billion (b) Rs. 166.67 billion (c) Rs. 375 billion (d) Rs. 666.7 billion
(viii) Which of the following marks the beginning of a contraction in the business cycle?
(a) Peak (b) Trough (c) Expansion (d) Recession
(ix) Government may increase the money supply through open market operations but such
measures are likely to result in short-term interest rates to:
(a) rise and increase the demand for money
(b) rise and reduce the demand for money
(c) fall and increase the demand for money
(d) fall and reduce the demand for money
(x) Consider the following data for a country:

Rs. in billion
Consumer expenditure 250
Government expenditure 500
Imports 100
Taxes 20
Depreciation 5
Based on the above data, the aggregate demand for the economy would be:
(a) Rs. 625 billion (b) Rs. 850 billion (c) Rs. 650 billion (d) Rs. 825 billion
(xi) Which of the following policies help in increasing economic growth?

(a) Increase in taxes (b) Increase in government spending
(c) Reduction in subsidies (d) Wage freezes
(xii) Which of the following is NOT regarded as a money market instrument?

(a) Commercial papers (b) Certificate of deposits
(c) Treasury bills (d) Bonds
(xiii) Which of the following policy combination is likely to solve a deficit on the current
account of the balance of payment in an economy with a floating exchange rate?
(a) Decrease interest rates and increase income tax rates
(b) Increase interest rates and decrease income tax rates
(c) Decrease interest rates and decrease income tax rates
(d) Increase interest rates and increase income tax rates
(xiv) Suppose in an economy, the average price level is 1.3, real value of national output is
Rs. 230 billion and the quantity of money in circulation is Rs. 103 billion. The velocity
of circulation would be:
(a) 2.90 (b) 1.60 (c) 0.72 (d) 0.58
(xv) The most effective macroeconomic policy to increase output under fixed exchange rates
and perfect capital mobility would be:
(a) an expansionary monetary policy (b) a revaluation of the domestic currency
(c) an expansionary fiscal policy (d) an increase in taxes
Section B
Q.6 (a) Identify and describe the stage of business cycle which eventually takes the economy
into recession. (04)
(b) Alongside the benefits of economic growth, certain costs are also associated with it.
Identify and discuss the costs associated with economic growth. (06)
Q.7 (a) What is a capital market? State its main objectives. (03)
(b) What do you understand by the term ‘Derivatives’? State the main objective of
exchange traded derivatives. (03)
(c) The current account, the capital account and the financial account make up country’s
balance of payments.
Briefly describe the components of the financial account. (04)

Q.8 (a) State Keynes’ Psychological Law of Consumption and the allied propositions. (04)
(b) Briefly describe any four objective factors which influence the consumption function in
an economy. (06)
Q.9 (a) Identify four main objectives of fiscal policy and briefly describe how these objectives
may be achieved. (04)
(b) In recent times, public expenditure has increased enormously. Briefly describe any four
principal causes of growing public expenditure of nations. (06)
Q.10 (a) What do you understand by the term ‘Bank’? Briefly describe the following:
(i) Retail bank (ii) Specialized bank (iii) Investment bank (06)
(b) Identify any eight functions of a central bank. (04)
Q.11 (a) What is meant by ‘Exchange rate’? Briefly describe the impact of fall in exchange rate
on a country’s exports and imports. (04)
(b) Illustrate with the help of a diagram, how the government may stop exchange rate
from falling. (06)
Q.12 (a) The following data relates to an open economy:
Consumption expenditure 0.4Yd

Investment expenditure (Rs.) 300 million
Government expenditure (Rs.) 600 million
Exports (Rs.) 500 million
Imports 0.28Y
Where Y is the national income and Yd is the disposable income which is equal to
70% of the national income.
Required:
Calculate the following, showing necessary workings:
(i) equilibrium level of national income. (02)
(ii) fiscal surplus/deficit, if the rate of taxation is 30%. (02)
(b) According to the monetary economist Milton Friedman, a trade-off exists between
unemployment and wage inflation but only in the short-run. In the long-run, no such
trade-off exists.
Explain, with the help of a diagram, the arguments put forward by Friedman in this
regard. (06)
(THE END)
Suggested Answers
Ans.1 (a) Capital formation:

Capital formation is the net capital accumulation for a particular country and refers
to the additions or increase in the stocks of capital in that country. Capital goods
include machines, tools, factories, transport equipment, materials, electricity, etc.
Stages involved in the process of capital formation

The process of capital formation involves the following three stages:
(i) Creation of savings:

When the average level of income is high then people tend to save more. An
increase in the volume of real savings releases resources which otherwise
would have been devoted to the production of consumption goods.
(ii) Mobilization of savings:

It involves transfer of savings from the households to businesses for
investment.
(iii) Investment of savings:

Investment of savings in real capital is integral for the capital formation. This
can only happen if there are enough entrepreneurial ventures and businesses
that are willing to take risks and embrace uncertainty.
(b) (i) Production possibility curve:
(ii) Opportunity cost of producing 50 more units of consumer goods would be 40

units of capital goods.
Ans.2 (a) Equi-marginal utility:

According to the law of Equi-Marginal Utility, a consumer maximizes his total
utility with his limited income when marginal utility of the last rupee spent on each
commodity is equal.
Assumptions of Law of Equi-Marginal Utility:

(i) The consumer behaves rationally and seeks to maximize his total satisfaction
(ii) Utility is measurable in cardinal terms/quantitative terms
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(iii) The consumer has a given scale of preference for the goods in consideration
(iv) The consumer has perfect knowledge of utility derived from goods
(v) Wants and goods are substitutable
(vi) Prices of goods remain unchanged
(vii) Consumer income is fixed
(viii) The marginal utility of money is constant
Limitations of the Law of Equi-Marginal Utility:

Consumer expenditure may not conform to the law due to the following
limitations:
(i) Consumers do not make conscious calculations

The operation of the law involves calculations and comparison of the
expected satisfaction from an amount of money spent on alternative goods
and services. However, consumer expenditure is also based on habit rather
than conscious calculation and comparison of utility per unit of currency.
(ii) Consumer ignorance

Consumers may be unaware of other available alternatives. In this case no
substitution could take place and the law would not operate.
(iii) Custom and fashion

Some purchases are made based on custom or fashion rather than on the
basis of a rational appraisal of utility. This would distort the operation of the
law.
(iv) Indivisibility of goods

The operation of the law assumes that goods and services are divisible so that
the optimum point might be reached. However, this may not be the case in
practice. This prevents the marginal utilities from becoming equalised.
(v) Underlying assumptions

The operation of the law rests on a series of assumptions which might not
hold in practice.
(b) Factors which determine the price elasticity of demand of a commodity:

Following are the factors which determine the price elasticity of demand:
(i) The availability of substitutes
(ii) The proportion of consumer’s income spent
(iii) The number of uses of a commodity
(iv) Complementarity between goods
(v) Time period
Classification of the goods according to the sign of IED and XED:

Income elasticity of demand (IED):
 A normal good will always have a positive income elasticity of demand,
because as income increases, demand for the product also increases.
 An inferior good will always have a negative income elasticity of demand,
because as income increases, demand for the product will decrease, as
consumers switch to better alternatives.
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Cross price elasticity of demand (XED):

 A complementary good has a negative cross price elasticity of demand,
because the two factors i.e. Good A’s price, and Good B’s quantity move in
opposite directions.
 A substitute good has a positive cross price elasticity of demand, because the
two factors i.e. Good A’s price, and Good B’s quantity move in the same
direction.
Ans.3
The above diagram depicts the concept of long run equilibrium of a firm under perfect
competition.
In perfect competition every purchaser and seller is so small relative to the entire market
that he cannot influence the market price by increasing or decreasing his purchases or
output. Therefore, the market price remains the same regardless of firm’s output.
The demand curve is completely horizontal, which means that sale of each additional unit
produces the same revenue and therefore MR=AR=P(Price). MC is the marginal cost
curve which depicts the increase in cost on account of production of each additional unit.
With the sale of each additional unit the total profit of the firm would increase till such
time that the MC remains below the Marginal Revenue Curve i.e. PL. The profit will be
maximum at point R where MC curve cuts PL from below because above this point each
additional unit will cost more than the revenue it would generate. At this stage (i.e. point
R) Marginal Cost would be equal to Marginal Revenue and the firm would be producing
OM units.
In the long run, the firms are able to increase /decrease their output by varying their
equipment. Therefore, in the long run no firm is in a position to earn super normal profits
and all firms earn normal profit which is depicted by the area OPRM where the total cost
and total revenue of the firm are the same.
Ans.4 (a) Short-run average cost curve is U shaped:

The average cost is made up of an average fixed cost per unit plus an average
variable cost per unit.
Average fixed cost will fall as the level of output rises. Spreading fixed costs over a
larger amount of output is a major reason why (short-run) average costs per unit
falls as output increases.
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The standard assumption about the variable costs is that up to a certain level of
output, the variable cost per unit is more or less constant (e.g. wages and material
costs per unit of output remain unchanged).
Nevertheless, there is evidence that average variable costs rise when output
increases beyond a normal capacity level.
Average variable costs will therefore begin to rise at some point, even if there are
no overtime payments or use of more skilled labour.
As variable costs per unit rise, the average total cost per unit will rise too.
Hence the curve falls on account of spread of fixed costs and rises when the
variable costs start rising after a certain level, thus giving the curve a U shape.
(b) Law of variable proportion:

As the quantity of one factor is increased, with others remaining fixed, the
marginal product of that factor will decline.
Assumptions of the law of variable proportion:

The law is dependent on the following assumptions:
(i) Constant state of technology:
if technology improves, the marginal product could increase also.
(ii) Fixed amount of other factors / Factor proportions are variable:

they must stay constant to be able to test it. It operates in the short run
because in the long run fixed input becomes variable.
(iii) Possibility to combine factors:

the factors must be able to be combined to make a product.
Ans.5 (i) (b) Mudaraba

(ii) (a) Government should provide basic health care to all citizens
(iii) (b) supply of 6 units
(iv) (c) inelastic
(v) (b) there are no barriers on entry of new firms
(vi) (b) Rs. 341 million [formula is 1/(1-MPC (1-t)) or 1/(1-0.8 x (1-0.3)) x 150]
(vii) (c) Rs. 375 billion [formula is 500/200 x 150]
(viii) (a) Peak
(ix) (c) fall and increase the demand for money
(x) (c) Rs. 650 billion [formula is C + G – X or 250 + 500 - 100]
(xi) (b) increase in government spending
(xii) (d) Bonds
(xiii) (d) Increase interest rates and increase income tax rates
(xiv) (a) 2.9 [formula is v = p x y / m or 1.3 x 230/103]
(xv) (c) an expansionary fiscal policy
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Ans.6 (a) The stage of business cycle which takes the economy into recession:
Downturn is the stage where the economic activity begins to slow down.
When demand begins to decrease, firms begin to scale back their production and
investment plans. There is a steady decline in output, profits, prices and
employment as demand falls, and firms respond by reducing their output.
Banks reduce the credit they issue, firms reduce orders that they place, and people
begin to lose their jobs, which further decreases the level of aggregate demand. This
eventually takes the economy into a state of recession.
(b) The costs associated with economic growth.

Following are some of the costs associated with economic growth.
(i) Inflation:
When economy grows too quickly, Aggregate Demand exceeds Aggregate
Supply because of which economic growth is not sustainable as it results in
positive output gap which prompts the firms to push up their prices.
(ii) Current account deficit:

Economic growth causes an increase in spending on imports which
consequently causes a deficit on the current account.
(iii) Inequality:
More often increase in the rate of economic growth results in an increased
level of inequality because the growth may benefit a small section of the
society more than the others.
(iv) Negative externalities / Environmental costs:

Rapid growth can give rise to plenty of environmental concerns; which
includes noise pollution, air pollution, road congestion, household and
industrial waste, deforestation, etc.
Ans.7 (a) Capital market:

Capital market is the financial market which is largely used to raise long-term
finance and capital.
Objectives of capital market:

Capital market plays a vital role in mobilizing the savings and making them
available to the enterprising investors.
It facilitates the buying and selling of capital instruments.
The capital market provides long-term debt and equity finance for the government
and corporate sector.
(b) Derivatives:
Derivative is an instrument whose price is dependent on one or more underlying
asset(s). It is a contract between two parties. The price of a derivative changes with
the change in the underlying asset(s).
Objective of exchange traded derivatives (ETD):

The main objective of ETD is to reduce the level of counterparty risk, as trades are
done by means of regulated contracts through a clearing house.
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(c) Components of financial account:

Following are the components of financial account with brief description of each:
(i) Real foreign direct investment:

A firm setting up a factory in another country.
(ii) Portfolio investment:

a domestic investor buying shares in a business that is already established.
Such investors have little or no control over these companies.
(iii) Financial derivatives:

financial instruments where the underlying value is based on another asset.
(iv) Reserve assets:

these are foreign financial assets held by Central Bank which uses them to
cover deficits and imbalances.
Ans.8 (a) Keynes’ Psychological Law of Consumption:

According to Keynes Psychological Law of Consumption, people increase their
consumption as their income increases, but not by as much as their income
increases.
The law consists of three related propositions:

(i) Aggregate consumption can increase due to increased aggregate income, but
the increase in aggregate consumption will be less than the increase in
income. This is because as basic necessities are fulfilled, people begin to save
additional income.
(ii) What is not spent on consumption is saved. (∆Y=∆C+∆S)
(iii) The increase in aggregate income will lead to increased consumption or

savings. It is not possible for savings and consumption to decrease when
income increases.
(b) Objective factors influencing the consumption function:

Following are the factors which influence consumption function in an economy:
(i) Real income:

Increase in real income would lead to increase in consumption and vice versa.
(ii) Distribution of income:

Change in pattern of income distribution would result in change of
consumption. A more equal distribution of wealth will raise the propensity to
consume.
(iii) Expectations of price changes:

If prices are expected to rise, people will be motivated to spend more and
accumulate goods, hence increase in consumption.
(iv) Changes in fiscal policy:

Reduction in taxes would leave more post-tax incomes with the people and
this will stimulate higher expenditure on consumption.
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(v) Changes in interest rates:

Decrease in interest rates would increase the amount of disposable income of
people and thus encourage consumption.
Ans.9 (a) Objectives of fiscal policy:

Following are the objectives of fiscal policy:
(i) High level of Employment: The state expenditure are directed towards public
projects thereby creating employment with productivity.
(ii) Resource Mobilization: Fiscal mechanism attempts at resource mobilization by

creating a climate conducive to savings and investments, by influencing their
relative profitability.
(iii) Resource Allocation: A fair share of resources is allocated to different sectors

and regions through the budgetary mechanism.
(iv) Economic stability: Undesired pace of inflation or deflation is controlled by way

of taxation and government spending.
(v) Income Distribution: Fiscal policy is a combination of taxation and relief

measures which are used to correct imbalances resulting from the unequal
distribution of ownership of income earning assets.
(b) Principal causes of growing public expenditure:

Following are some of the reasons of continuous increase in public expenditure:
(i) Welfare state ideology:

the state is expected to promote the wellbeing of its citizens in every respect
i.e. politically, economically and socially. With increased number of
functions and higher expectations, State needs more to spend on public
expenditure than before.
(ii) Size of population:

because of ever-increasing size of population the government has to cater to
the structural and social needs of the increased population.
(iii) Technological developments:
technological advancements play an integral role in the economic growth of
the country but at the same time also cost a lot. For instance, invention of
combustion engine led to the manufacturing of automobiles for which roads
and highways were necessary to be built thus increasing the government
expenditure.
(iv) Ability to tax:

As the economies are growing, the government’s ability to generate
revenues/taxes is increasing making it possible to increase expenditure to
provide better facilities to the public.
(v) Expansion in social services:

there has been a remarkable expansion in social services such as education
and public health services leading to the development of schools, colleges,
educational institutes, hospitals and medical centres that in turn require
finances for establishment and stability.
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(vi) Provision of public utility services:

Another significant increase in the public expenditure is due to an augmented
provision of public utility services such as electricity, water and transport
services.
(vii) Political and social factors:

The government expenditure also increases due to various political and social
factors.
For instance, ministers are pressurized to undertake more activities to bring

about changes in their home districts.
(viii) Economic development:

Whether developed or under-developed, every country eyes on the economic
development in order to reach economic stability and higher standard of
living of its people. Developed countries wish to retain their progress and aim
for even higher milestones whereas developing countries are anxious to reach
there. Undoubtedly, therefore the budgets get swollen more and more with
every passing year.
(ix) War and the national defence:

Wars have always been a great threat for every country. Even in modern
times the fear has only increased, making countries spend more on the
national defence. Countries at war have to ultimately spend heavily on the
subject.
Ans.10 (a) Bank:

A financial institute licensed by the government to receive deposits, which then
invests these funds in a number of securities.
(i) Retail bank:

A bank targeted at the mass-market in which individual customers can
purchase/obtain mortgages, checking accounts, personal loans, and other
bank services.
(ii) Specialized bank:

A bank targeted to a specific section of the economy in which firms and
customers can have access to specialized forms of banking services.
(iii) Investment bank:

A financial intermediary that undertakes a number of financial services for
clients such as raising capital, underwriting securities and other assets,
providing advice, etc.
The investment bank can also aid companies with acquiring funds, and
facilitate a number of transactions through utilising the financial markets.
An investment bank does not accept deposits.
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(b) Functions of a central bank:

(i) issuing currency notes
(ii) banker to the state
(iii) banker to other banks
(iv) guardian of the money market through the control of credit
(v) lender of last resort
(vi) maintaining the external value of the domestic currency
(vii) custodian of foreign exchange reserves
(viii) ensures stability of the internal value of the currency i.e. price level
(ix) overall economic stability of the country
(x) clearing agent for commercial banks
Ans.11 (a) Exchange rate:

The exchange rate is the price of one currency expressed in terms of another
currency.
Impact of fall in exchange rate on country’s exports and imports:

As the exchange rate falls, the demand for country’s exports extends as
depreciation makes exports cheaper and increases the competitiveness of exporting
firms.
As the exchange rate falls, imports look less attractive as imported goods become
more expensive for both the direct consumer and the domestic producer using them
for further processing. Consequently, country’s demand for imports contracts.
(b) How the government may stop exchange rate from falling:
Suppose the government wishes the rate to be at Rt. Policy options are:
 Increase the domestic interest rate and hence shift the demand curve for rupees
from D to D1.
 Purchase the surplus rupees (Qs-Qd) using foreign exchange reserves.
Deflate the economy to reduce the demand for imports. This will shift the supply
curve of rupees from S to S1.
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Ans.12 (a) (i) Equilibrium level of national income:

The equilibrium level of national income is given by:
Y=C+I+G+X-Z
OR Y = 0.4 Yd + 300 + 600 + 500 – 0.28Y
Y = 0.4×0.7Y + 1,400 – 0.28Y
Y = 0.28Y + 1,400 – 0.28Y = 1,400
(ii) Fiscal surplus / deficit:

The fiscal balance is given by:
T – G where T is the income from taxes and G is the government expenditure.
Therefore, T = 1,400 × 30% = 420 and
420 – 600 = 180 million (deficit)
(b) With the help of a diagram, explanation of the arguments put forward by Milton
Friedman with regard to long run Phillips curve and a trade-off between
unemployment and inflation:
Milton Friedman’s argument was that each short-run Phillips curve (SRPC) is
based upon a fixed expectation of inflation. If there is an increase in the expectation
of inflation, then this would cause the SRPC to shift higher.
Diagrammatically it can be illustrated as follows:
In the above diagram, The economy begins in equilibrium at A.
When there is an increase in government spending to boost Aggregate Demand

(AD), the unemployment decreases from U1 to U2 and takes the equilibrium to
point B where inflation is 6%.
At point B, firms’ costs and individuals’ wage demands increase, meaning output
falls, unemployment rises, and hence SRPC1 shifts to SRPC2.
Therefore, in the short run, a trade off may occur, however in the long run, it is not
possible to expand beyond the long-run Phillips curve (LRPC).
(THE END)
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Section A
Q.1 (a) Economic problems affect different agents within an economy in different ways.
Define three main types of such agents in an open economy. (03)
(b) What do you understand by the term ‘Planned economy’? How resource allocation
choices are made in a planned economy? Also state any three benefits of planned
economy. (05)
Q.2 (a) Describe the law of demand. Support your answer with the help of a diagram. (05)
(b) Briefly describe any four exceptions to the law of demand. (06)
Q.3 Explain the concept of consumer equilibrium with the help of indifference curve analysis. (08)
Q.4 Briefly describe the following diagram and the concept which it depicts. (08)
(i) Which of the following is NOT a basic question of economics?

(a) What will be produced? (b) Where it will be produced?
(c) For whom will it be produced? (d) Who will produce it?
(ii) Smart phones have become the latest craze. Everyone wants to have the smart phone
and its sales are increasing. Therefore, the factory has increased production. This is an
example of:
(a) circular flow (b) due process
(c) opportunity cost (d) consumer sovereignty
(iii) Which of the following would unambiguously occur when there is a simultaneous
decrease in demand and supply?
(a) An increase in equilibrium price
(b) A decrease in equilibrium price
(c) An increase in equilibrium quantity
(d) A decrease in equilibrium quantity
(iv) Which of the following is held constant along the demand curve?
(a) Price (b) Quantity (c) Income (d) Both (a) and (b)
(v) Which of the following is NOT a feature of monopolistic competition?

(a) Freedom of entry and exit to the industry
(b) Downward sloping demand curve
(c) Identical products
(d) Many firms supplying the market
(vi) Aggregate supply increases due to increase in:

(a) labour productivity (b) consumer spending
(c) wage rate (d) interest rates
(vii) If the reserve requirement is 20% and banks hold no excess reserves, an open market
sale of government securities of Rs. 60 million by the central bank will:
(a) increase the money supply by up to Rs. 300 million
(b) decrease the money supply by up to Rs. 300 million
(c) increase the money supply by up to Rs. 12 million
(d) decrease the money supply by up to Rs. 12 million
(viii) Induced investment is the investment which is:

(a) income-inelastic (b) income-elastic
(c) independent of profit (d) motivated by the well being of society
(ix) Along with the benefits, certain costs are also associated with economic growth. These
include:
(a) high unemployment (b) decrease in tax revenue
(c) inflation (d) stagflation
(x) Which of the following is NOT a major determinant of the consumption function?
(a) Political instability (b) Real income
(c) Distribution of wealth (d) Changes in fiscal policy
(xi) Which of the following is a non-monetary measure for correcting current account
deficit?
(a) Exchange rate depreciation (b) Tariffs
(c) Interest rate appreciation (d) Exchange control
(xii) Which of the following is regarded as ‘Fiat money’?

(a) Gold (b) Gold standard
(c) Credit card (d) US dollar
(xiii) Which of the following measures is NOT likely to boost a country’s rate of economic
growth?
(a) Tax cuts (b) Tax rebates
(c) Reduction in subsidies (d) Increase in government spending
(xiv) Which of the following is NOT related to the capital market?

(a) Commercial banks (b) Mercantile exchanges
(c) Stock exchanges (d) Insurance companies
(xv) The restrictive monetary policy in an open economy with flexible exchange rate is
most likely to result in:
(a) higher interest rates and an exchange rate appreciation
(b) higher interest rates and an exchange rate depreciation
(c) lower interest rates and an exchange rate appreciation
(d) lower interest rates and an exchange rate depreciation
Section B
Q.6 (a) Explain the concept of ‘Marginal propensity to save’ and how it is calculated. Also
explain any four determinants of savings. (07)
(b) Briefly describe the concepts of ‘Autonomous and Induced consumption’. (03)
Q.7 (a) Draw a diagram of the circular flow of national income. (04)
(b) Briefly discuss any two causes each of ‘Cost-push inflation’ and ‘Demand-pull
inflation’. (06)
Q.8 (a) What is ‘Credit money’? Give two advantages and disadvantages of credit money. (06)
(b) ‘Central bank uses monetary policy to achieve number of objectives in an economy.
However, due to conflicting situations, it is not possible to achieve all of these
objectives at once’.
Briefly describe any two conflicts which may exist between these objectives. (04)
Q.9 (a) Describe the principle of accelerator. Also state the assumptions underlying the
principle of accelerator. (05)
(b) Identify and explain any four limitations of ‘Multiplier’. (05)
Q.10 (a) Briefly explain ‘Liquidity preference theory’. Briefly describe the three motives,
identified by Keynes which determine an individual’s demand for holding money in
liquid form. (07)
(b) What is meant by ‘Keynesian liquidity trap’? Identify any two policies which may
help in breaking out of the liquidity trap. (03)
Q.11 (a) What is meant by ‘Regressive’, ‘Proportional’ and ‘Progressive’ taxes? Give one
example of each of the above types of taxes in the context of Pakistan. (06)
(b) State any eight characteristics which are important for creating a good system of
taxation. (04)
Q.12 (a) Briefly explain ‘Balance of payment’, ‘Balance of trade’ and ‘Terms of trade’. (06)
(b) Describe any four corrective measures which may be adopted to improve the balance
of payment position in Pakistan. (04)
(THE END)
Suggested Answers
Ans.1 (a) The economic problem affects different agents within an economy in different ways.
In the simplest form of an economy, the main types of agents are as follows:
(i) Households (consumption units):

The collective group of individuals not only consuming goods and services,
but also providing labour for firms.
(ii) Firms (production units):

The collective group of organisations producing goods and services in an
economy.
(iii) Government/state:
It governs over society through a combination of customs, exercises and
laws.
(iv) Foreign traders:

The collective group who exchange goods and services between different
economies.
(b) Planned economy:

It is a type of economic system in which allocation of resources is decided by the
government rather than markets.
How resource allocation choices are made:

In a planned economy, the decisions and choices about resource allocation are
made directly and with the force of law by the Government.
Productive resources are state owned and the state decides how they should be used
for the common good.
Resources are allocated by decree through an administrative system.
Benefits of planned economy:

Following are the benefits of planned economy:
(i) production is carried out for the needs of society and not for the benefit of the
few.
(ii) the social costs of production and consumption are considered in economic
decisions.
(iii) full employment of the workforce is possible.
(iv) less duplication and waste of resources.
(v) permits long term industrial and social planning fostering economic stability.
(vi) considered a more equal, classless system with equality of opportunity.
SMEX AMA AS GH SMF
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Ans.2 (a) Law of Demand:

As the price of a product falls, ceteris paribus, the demand for the product extends and
conversely. As the price of a product rises, ceteris paribus, the demand for the good
contracts.
The demand can be represented graphically as a downward sloping curve (This is in

accordance with the law of diminishing marginal utility).
The demand curve shows how the quantity purchased varies with the variation in
price. Along OX are represented the quantities of the good purchased and along OY
the prices. At the price OP, OM quantity is purchased, at OP’ the quantity
purchased is ON and at OP’’ the quantity is OL. As the price falls, more quantity is
purchased, and vice-versa.
(b) Exceptions to the law of demand:
(i) Change in Taste or Fashion:

According to the law of demand, when price falls, demand is expected to
increase. But if in the meantime consumer’s tastes undergo a change or if the
commodity going out of fashion, more may not be demanded even if the price
falls.
(ii) Change in Income:

A rise in price is likely to result in a diminution of demand according to the
law of demand. But if the consumer’s income has gone up, he may be willing
to buy more in spite of the rise in price.
(iii) Change in Other Prices:
The law of demand says that if the price of a commodity, say tea, falls, more
tea will be demanded. But if the price of coffee falls even more heavily, more
tea may not be purchased; instead more coffee may be purchased.
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(iv) Discovery of Substitutes:

Acting on the law of demand, the price of jute may be lowered to boost the
sales of jute but discovery of cheap substitutes like synthetic bags may nullify
the efforts and more jute may not be demanded even if the price of jute falls.
(v) Anticipatory changes in prices

Anticipatory changes in prices may also upset the law of demand. It is often
seen that there is stockpiling of commodities and larger purchases even
through the prices are rising. This may be due to the fact that either on
account of the danger of war or widespread failure of rains, shortage is feared
and future rise in prices is expected.
(vi) Distinctive use of commodity:

The law of demand does not hold good also when a commodity is such that
its use confers distinction. In case of such a commodity, a fall in its price will
keep off the purchasers, because the use of a cheap commodity cannot be
considered as a mark of distinction.
Ans.3 The consumer is said to be in equilibrium when the maximum possible satisfaction is
obtained from the individual’s purchases, at the prices prevailing in the market and the
amount of money the individual possesses for making purchases.
The consumer’s equilibrium can be demonstrated by means of Indifference Curve using

the following diagram:
(i) AM is the budget line (consumer’s price line). Each point on the line represents a
combination of quantities of products A and B which the consumer can buy at the
prevailing prices, given the amount of money the individual has to spend on the two
products. Hence the equilibrium must be on some point on this line.
(ii) Each point on the indifference curve represents the same level of satisfaction. The
level of satisfaction increases as the individual moves from lower indifference curve
to higher indifference curve i.e. the individual is at a lower level of satisfaction at the
combinations represented by IC1 and at a higher level of satisfaction when on IC2
and so on.
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(iii) IC3 is the highest indifference curve to which the individual can go, given the money
and the prices of the goods in the market. The price line is tangent to the
indifference curve at point P which is the point of maximum satisfaction because all
other points on the curve are beyond the budget line.
(iv) Thus the consumer will be in equilibrium when the individual purchases OH
quantities of product A and OJ quantities of product B.
Ans.4
The above diagram depicts the concept of long run equilibrium of a firm under
monopolistic competition.
In the diagram, AR = Average revenue curve, MR = Marginal revenue curve, LAC =

Long run average cost, LMC = Long run marginal cost.
In the long run the firms earns normal profit as new firms enter the industry and starts
production due to which supply increases and the price falls. The average revenue curve is
more elastic (i.e. flatter), since large number of substitutes are available in the long-run.
AR is a tangent to the LAC at P. The equilibrium output in the long-run is OM and the
corresponding price is MP (=OP’). Therefore, at this point the firm is in equilibrium as
both average revenue and average cost is MP and the firm is earning normal profits.
In the long-run, the following two conditions must hold. i.e.

Marginal Revenue = Marginal Cost and
Average Revenue = Average Cost
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Ans.5 (i) (b) Where it will be produced?

(ii) (d) consumer sovereignty
(iii) (d) A decrease in equilibrium quantity
(iv) (c) Income
(v) (c) Identical products
(vi) (a) Labour productivity
(vii) (b) decrease the money supply by up to Rs. 300 million (1÷20%×60)
(viii) (b) income-elastic
(ix) (c) Inflation
(x) (a) Political instability
(xi) (b) Tariffs
(xii) (d) US dollar
(xiii) (c) Reduction in subsidies
(xiv) (b) Mercantile exchanges
(xv) (a) higher interest rates and an exchange rate appreciation
Ans.6 (a) Marginal propensity to save (MPS):

MPS is the proportion of each additional Rupee of household income that is saved.
It is calculated as under:
Determinants of savings:
(i) Level of income
Saving is determined by the level of income. There is a direct relation
between the two i.e., savings increase as the level of income increases.
(ii) Net wealth

A household’s net wealth is the value of all assets owned by a household, less
any liabilities or debt owed. A decrease in net wealth would make consumers
less inclined to spend and more inclined to save at each income level.
(iii) Interest rate

Interest is the reward for increasing savings by reducing consumption and the
amount paid by borrowers for current spending power. An increase in
interest rate, other things held constant, will lead to less spending and thus
higher savings.
(iv) Objective and institutional factors

Factors such as political stability and security of property encourage people to
save more. Similarly, an established system of banks and other financial
institutions promotes savings by way of interest earning motives.
(v) Subjective motivations for savings

According to Keynes, there are multiple factors that motivate individuals and
enterprises to save such as to provide for future needs, to build up a reserve
against unforeseen contingencies, to undertake business projects, to expand
business investments and to have financial prudence in discharging debts.
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(vi) Income distribution:

Aggregate savings rate also depends upon the distribution of income and
wealth in the community. If there is a greater degree of inequality of income
among the people, aggregate savings rate would tend to be high.
(vii) Consumption motivations:

Saving is the residual part of income left after consumption. Thus, to know
the factors affecting saving, we must know what factors determine
consumption. The consumption of the community depends upon a variety of
factors and motivations.
(viii) Population growth:

A high growth of population has an adverse effect on the per capita income
which causes an adverse effect on the saving-income ratio.
(b) Autonomous consumption:

Autonomous consumption is the minimum level of consumption or spending that
must take place even if a consumer has no disposable income. This consumption is
typically used to fund consumer necessities.
Induced consumption:
When a change in disposable income “induces” a change in consumption on goods
and services, that changed consumption is called “induced consumption”.
Ans.7 (a) Circular flow of national income:
(b) Causes of Cost-push inflation:

(i) Rising labour costs:
When level of unemployment in an economy is low, skilled labor would be in
a position to demand higher wages which would give rise to cost-push
inflation.
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(ii) Expectations of inflation:

When people in an economy anticipate higher inflation, they may demand
higher wages to protect their real income. Higher wages would increase the
costs to a firm which would ultimately fulfil the expectation of higher
inflation.
(iii) Component costs:

An increase in the price of raw materials and other inputs would give rise to
cost-push inflation.
(iv) Higher indirect taxes:

Imposition of indirect taxes would result in higher costs for the firms which
would ultimately pass on to end consumers resulting in cost-push inflation.
(v) Cost of imports rising:

The exchange rate depreciation would make imports more expensive. In an
economy where demand for imports is inelastic, exchange rate depreciation
would lead to cost-push inflation.
Causes of Demand-pull inflation:

(i) Fiscal stimulus:
Fiscal stimulus will increase aggregate demand in the economy. Given the
effects of multiplier, an increase in government spending would result in
greater increase in demand which would lead to demand-pull inflation.
(ii) Monetary stimulus:

Monetary stimulus such as fall in interest rates, buying of government
securities etc. would trigger an increase in demand because of a situation ‘too
much money chasing few goods’. The surplus demand would increase the
price level and therefore, demand-pull inflation.
(iii) Depreciation of the exchange rate:

If exports become cheaper to foreigners, and a comparative amount of imports
aren’t bought, aggregate demand will shift outwards, causing a rise in the level
of inflation.
(iv) Fast growth in other countries:

Especially if they purchase from the economy in question, will increase the
demand for those goods, and therefore increase the demand and prices.
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Ans.8 (a) Credit money:

Any monetary claim against a physical or legal person that can be used for the
purchase of goods and services. Virtually any form of financial instrument that is
not repaid immediately is considered credit money.
Advantages of credit money:

 Allows immediate consumption of expensive goods, based on future earnings
(this includes houses, education, cars, which could otherwise not be bought).
 Allows firms to invest, expand and generate future revenue, rather than use
retained earnings.
Disadvantages of credit money:

 There is often an element of risk involved that the person issuing credit may
not receive full payment from the person receiving credit.
 It may lead to over spending.
(b) Mutual conflicts which may exist between the objectives of monitory policy:
(i) Price stability vs full employment

By undertaking monetary policy to increase full employment, a central bank
could undertake policies to increase aggregate demand. Doing so could drive
up inflation, putting more pressure on the price stability target.
(ii) Economic growth vs exchange rate stability

In order to boost economic growth, a central bank may decide to manipulate
exchange rates to increase the likelihood of exports. Doing so would endanger
stability in exchange rates.
(iii) Economic growth vs credit control

Expansion of credit would spur investment and spending resulting in growth.
However, this comes with heightened economic risk of credit defaulting.
Ans.9 (a) Principle of accelerator:

It is the ratio between the change in induced investment and a change in national
income occurring through a change in consumption.
Assumptions of the principle of accelerator:

(i) The basic assumption of the principle of accelerator is the constant capital
output ratio.
(ii) Real profits move with the aggregate output.
(iii) Resources are considered to be elastic so that investment in new capital goods
can be undertaken easily.
(iv) Money supply especially credit money is considered to be elastic so that funds
for induced investment are readily available.
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(b) Limitations of Multiplier:

(i) Efficiency of Production:
If the production system of the country cannot cope with increased demand
for consumption goods and make them readily available, the incomes
generated will not be spent as envisaged.
(ii) Regular Investment:

The value of the multiplier will also depend on regular repeated investments.
A steadily increasing level of investment is essential to maintain the
momentum of economic activity.
(iii) Leakages:
Leakages from the circular flow of income would lower the value of multiplier
and extra spending in the economy would have nominal effect, particularly
where there is a high marginal propensity for imports.
(iv) Multiplier Period:

A long period of adjustment would be required before the benefits of
multiplier are realized.
(v) Full Employment Ceiling:

As soon as full employment of the idle resources is achieved, further beneficial
effect of the multiplier will practically cease.
Ans.10 (a) Liquidity preference theory:

Liquidity preference theory states that all factors remaining the same, people prefer
to hold cash (liquidity) rather than assets that are illiquid. They will, however, be
paid a premium to hold more illiquid assets.
The three motives for holding money in liquid form are:
Transactions motive:
Individuals need money to meet their day-to-day requirements of purchases of
goods and services. The need to hold money for transactions arises because the
payments and receipts of individuals are not exactly synchronised. The liquidity
preference or transactions demand for money will increase either by an increase in
the real national income or an increase in the general price level or any combination
of the two.
Precautionary motive:
Individuals keep money in hand or with banks as a precautionary measure to meet
any unforeseen fluctuations in receipts and payments. The precautionary demand
for money arises due to uncertainty regarding the timing and size of payments and
receipts. The higher the level of national income, the larger amounts of money
balances that would be needed for precautionary purposes, reflecting higher
liquidity preference.
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Speculative motive:
The holding of money has an opportunity cost in the form of income foregone by
not using the money to purchase an income bearing asset e.g. a bond. When
interest rates are high, individuals will hold lesser amounts for speculative purposes
and therefore have low liquidity preference. When the interest rates tend to be low,
individuals will retain large amounts in anticipation of increase in interest rates and
would have high liquidity preference.
(b) Liquidity trap

Liquidity trap is a situation where savings rates are high despite very low interest
rates, causing monetary policy to be ineffective.
The policies that may help in breaking out of liquidity trap are as follows:
Fiscal policy:
It is an important instrument in raising aggregate demand, for example running a
larger budget deficit by increasing public expenditure or reducing taxes.
Rising inflation expectations:

High rate of inflation would cause savings to be worthless. This will act as
disincentives for hoarding of cash, as its real value will decrease. Therefore
consumption will increase.
Expectation of low interest rate:

If the central bank convinces people that interest rates will stay low, they will have
less reason to postpone present spending.
Ans.11 (a) Regressive taxation:

A tax where lower income persons/entities pay a higher fraction of their income as
taxes than higher income persons/entities.
Example
(i) Sales tax at the rate of 17%.
(ii) Toll for accessing roads, bridges etc.
Progressive taxation:
It refers to a situation where the percentage of income paid in taxes increases as
income increases. The principle of progressive tax is: “higher the income, higher the
rate.”
Example
(i) Income tax on salaries in Pakistan
(ii) Tax on rental income from property
Proportional tax:
Also called a flat-rate-tax is charged at the same percentage on all income levels i.e.
the tax as a percentage of income remains constant as income increases.
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Example
(i) Income tax on companies
(ii) Tax on commercial importers
(b) Characteristics of a good tax system:

The characteristics of a good tax system are:
(i) persons should be required to pay taxes according to their ability i.e. it should
be equitable.
(ii) the tax should be certain and easily understood by all concerned.
(iii) the payment of tax should ideally be related to how and when people receive
and spend their income.
(iv) the cost of collection should be nominal relative to the yield.
(v) tax rates should be flexible so that they may be revised upwards and
downwards.
(vi) it should not harm initiative.
(vii) evasion of tax should be difficult.
(viii) the effects of taxation should be compatible with the social and economic
objectives of the community such as accelerating economic growth and
reduction of inequalities of income and wealth
(ix) the tax revenues should increase as the state expenditure increases.
Ans.12 (a) Balance of payment:

The Balance of Payments is a systematic and complete record of a county’s
transactions with other countries which takes place over a period of time. The
Balance of Payments is in deficit when a country’s outflows are more than the
inflows.
Balance of trade:
Balance of trade is a record of a country’s international trade transactions (import
and export of goods) with other countries during a given period of time. The
Balance of trade is in deficit when a country’s imports exceeds its exports.
Terms of trade
The quantity of domestic goods that a country must give up to obtain a unit of
imported goods is called the terms of trade.
(b) Corrective measures for improving balance of payment:

(i) Establishment of labour intensive industries:
Since labour is cheaper in Pakistan therefore labour intensive industries can be
set up and the products from such industries could be exported.
(ii) Export tariffs:

Reducing export duties will help us make our exports competitive in the
international market. Foreign countries would prefer to buy our products
because of reduced prices.
(iii) Joint ventures:

Establishing joint ventures with foreign investors can give a boost to our sales
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(iv) Controlled imports:

Imports of all luxury items should be discouraged and only the needed items
should be imported.
(v) Curbing immoral activities:

Many Pakistanis have brought a bad name to the country’s trade practices by
getting engaged in immoral activities such as exporting goods of inferior
quality than specified in the agreement. Government needs to exercise strong
control over it.
(vi) Market driven exchange rate:

The exchange rate should be free from government manipulation. It should be
based on free forces of demand and supply in the market.
(THE END)
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Certificate in Accounting and Finance Stage Examinations

Section A
Q.1 (a) What do you understand by the term ‘Factors of production’? What types of factors
of production are used by a school? (03)
(b) Briefly describe any four core features of Islamic economic system. (04)
Q.2 Describe the Law of ‘Diminishing marginal utility’. Support your answer with the help of a
schedule and a diagram. (07)
Q.3 (a) Define the concept of ‘Price elasticity of supply’ and how it may be calculated.
Identify the factors which would increase the price elasticity of supply. (05)
(b) What do you understand by ‘Reservation price’? Briefly describe three factors which
may affect the reservation price. (05)
Q.4 (a) Define the term ‘Economies of scale’? Describe any four ways by which a firm may
achieve internal economies of scale. (06)
(b) What is meant by ‘Oligopoly’? List any four advantages and disadvantages of
Oligopolies. (05)
(i) Which of the following concepts is NOT illustrated by the production possibility
curve?
(a) Efficiency (b) Opportunity cost
(c) Equity (d) Trade-off
(ii) An industry is a group of firms:

(a) located in the same geographical area
(b) producing similar products
(c) which supply the various inputs needed to produce a final product
(d) owned by a corporation
(iii) With 50 units of labour, a firm can produce 1,800 units of output. With 60 units of
labour the firm can produce 2,100 units of output. The marginal product of labour is:
(a) 0.33 (b) 3 (c) 30 (d) 300
(iv) Which one of the following will NOT shift the demand curve for a normal good to
the left?
(a) A fall in consumers incomes
(b) A rise in the price of a complementary good
(c) A fall in the price of the substitute good
(d) A rise in the price of the normal good
(v) Which one of the following is NOT a barrier to entry into a monopoly market?
(a) Significant economies of scale
(b) Heavy potential advertising costs
(c) Large capital requirements
(d) Constant returns to scale
(vi) The inverse relationship between rate of interest and level of investment is shown
by:
(a) supply curve
(b) the marginal efficiency of capital curve
(c) demand curve
(d) indifference curve
(vii) Which of the following is an objective of fiscal policy?

(a) Zero inflation
(b) Reduced money supply
(c) Low exchange rates
(d) Stable economic growth
(viii) Slow economic growth and high unemployment refers to:

(a) Stagflation (b) Hyper inflation
(c) Wage spiral inflation (d) Deflation
(ix) Murad pays a tax of Rs. 100 on his income of Rs. 1000 while Sohail pays a tax of
Rs. 200 on his income of Rs. 800. Identify the tax system prevailing in the country.
(a) Progressive (b) Regressive
(c) Proportional (d) Equitable
(x) The Phillips curve indicates that there is a trade-off between the objectives of:
(a) inflation and economic growth
(b) inflation and unemployment
(c) inflation and balance of payments
(d) inflation and exchange rate
(xi) Monetary policy can be effective if:

(a) the money supply reacts to changes in the interest rate
(b) money demand reacts to changes in the interest rate
(c) planned investment reacts to changes in the interest rate
(d) government spending reacts to changes in the interest rate
(xii) The Current Account of the Balance of Payments consists of:

(a) Trade in goods and services (b) Investment income
(c) Transfers (d) All of the above
(xiii) The protective measure of a government where only a fixed amount may be
imported into a country refers to:
(a) Import tariff (b) Export tariff
(c) Quota (d) Import substitution
(xiv) Whenever a commercial bank’s desired reserve ratio exceeds its actual reserve ratio
the bank will:
(a) call in loans and reduce reserves
(b) call in loans and increase reserves
(c) make additional loans and reduce reserves
(d) make additional loans and increase reserves
(xv) Which of the following is most likely to result from revaluation of a country’s
exchange rate?
(a) Exports will become less competitive
(b) Imports will become more expensive
(c) Inflation will rise
(d) Export volumes will rise
Section B
Q.6 (a) Illustrate the concepts of ‘Nominal interest rate’ and ‘Real interest rate’. (05)
(b) Illustrate the process through which the central bank may reduce the level of
aggregate demand in the economy using open market operations. (05)
Q.7 (a) What is inflation? Briefly state any four harmful effects of inflation on the economy. (05)
(b) Explain the concept of ‘Natural rate of unemployment’ with the help of a diagram. (05)
Q.8 (a) What is meant by ‘Economic growth’? Briefly describe the benefits of economic
growth. (08)
(b) In an open economy, the marginal propensity to consume is 0.7 and the proportion
of additional income that is spent on imported goods is 20%. National income is
Rs. 100,000,000 and the current account is in balance. What would be the new
equilibrium of national income if the government increases its expenditure by
Rs. 50,000,000? (02)
Q.9 (a) Define ‘Money market’. Briefly describe any two marketable instruments traded on
money markets. (04)
(b) Identify and describe the functions of money. (04)
(c) Compute the velocity of circulation of money in an economy using the Quantity
Theory of Money, where the average price level is 1.8, real GDP is Rs. 28,726
billion and the nominal money supply is Rs. 12,926 billion. (02)
Q.10 (a) ‘Income method measures the national income after it has been distributed and
appears as income earned or received by individuals of the country’.
List the items which are excluded from the computation of national income under
the income method. (03)
(b) Explain with the help of a diagram, the equilibrium of aggregate supply (AS) and
aggregate demand (AD) under neo-classical approach. (07)
Q.11 (a) Briefly describe the main functions of ‘Public finance’ as stated by Musgrave. (06)
(b) Explain any two limitations of fiscal policy. (04)
Q.12 What do you understand by ‘J curve’? Explain with the help of a ‘J curve’, how in the
short-run the current account deficit may get worse before improving. (10)
(THE END)
Suggested Answer
SECTION A
Ans.1 (a) Factors of production:

The factors of production are the resources used in producing any goods and
services.
Factors of production in case of a school:
(i) Land – The school needs land for constructing the school building,
assembly hall, playground, etc.
(ii) Labour – Both qualified and trained teachers and semi-skilled labours are
required for running the school.
(iii) Capital – Capital investment in building, furniture, laboratory equipment,
computers, library books, stationery, etc. is required.
(iv) Enterprise – School management which manages all the above
resources efficiently.
(b) The core features of Islamic economic system are as follows:
(i) Allah is the sustainer:

This describes the belief that Allah created all the resources available to
man and is responsible for feeding and nourishing all the creatures and
human beings.
(ii) Allah is the true owner of everything:

Man is merely a trustee of resources but has authority for using them in
fair support of his existence on earth and according to Allah’s instructions.
(iii) State ownership:

There is no ban on the state owning an enterprise. However, a free market
still exists where entrepreneurs can profit so long as they abide by the
other rules of the Islamic economic system.
(iv) Practising moderation:

Islam aims for a fair distribution of resources and the population is taught
to share wealth where they can. They are also taught to abstain from
extremes aiming for the ‘middle way’.
Ans.2 Law of diminishing marginal utility:

It means that additional benefit which a person derives from a given increase of his
stock of a commodity diminishes with every increase in stock that he already has.
Explanation with the help of schedule and a graph:

We assume that a person is very thirsty. He takes the glasses of water successively.
The marginal utility of the successive glasses of water decreases, ultimately, he
reaches the point of satiety. After this point the marginal utility becomes negative, if he
is forced further to take a glass of water. The behaviour of the consumer is indicated
in the following schedule:

1st glass 10 10
2nd glass 18 8
3rd glass 24 6
4th glass 28 4
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5th glass 30 2
6th glass 30 0
7th glass 28 -2
The law of diminishing marginal utility can be explained by the following diagram
drawn with the help of above schedule:
In the above diagram, the marginal utility of different glasses of water is measured on
the y-axis and the units (glasses of water) on X-axis. The marginal utility curve has a
downward slope. It intersects the X-axis at the point of 6th unit of the commodity (point
"F") where the marginal utility becomes zero. When the MU curve goes beyond this
point, the MU becomes negative. So there is an inverse functional relationship
between the units of a commodity and the marginal utility of that commodity.
Ans.3 (a) Price elasticity of supply:

It is a measure of the responsiveness of quantity supplied to a change in the
price of the goods. It is calculated as follows:
Percentage change in quantity supplied

Price elasticity of supply =
Percentage change in price
Where:
Percentage change in quantity supplied
New quantity supplied − old quantity supplied
=
Average quantity supplied
New price – old price

Percentage change in price =
Average price
Factors:
The following factors would increase the price elasticity of supply:
(i) Greater availability of stocks
(ii) Greater ability of firms to switch resources to and from substitutes in
production
(iii) Increased ease of entry and exit to and from the market
(iv) Shorter length of production process
(v) Availability of excess production capacity
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(b) Reservation price:

It is the minimum price a firm is willing to receive for its good.
Factors affecting reservation price:

The factors which may affect the reservation price are as follows:
(i) Disposable income of the buyers

Disposable income varies from person to person therefore the buying
decisions too change accordingly. A firm has to observe analytically the
buying patterns and the disposable income of the buyers in order to set a
reservation price for its commodities.
(ii) Substitute goods

If the substitutes are readily available and if the buyer is rational and has a
close watch on the related information, then the firm might need to set
lower reservation price for its product and vice versa.
(iii) Objectives
The nature of objectives also plays a key role in the determination of the
reservation price for the firms. For instance; a firm penetrating the market
may set a lower reservation price as compared to the firm which dominates
the market.
Ans.4 (a) Economies of scale:

Reduction in cost per unit resulting from large scale production are known as
economies of scale.
Internal economies of scale can be achieved in the following ways:

As the firm expands it can use larger and more efficient machines resulting
in greater efficiency and economy.

Larger firms can employ specialist managers to optimise the use of
resources. The cost per unit of clerical and administrative procedures will
also be lower as output grows.
(iii) Trading/commercial economies:

Larger size enables the firm to buy in bulk and sell in bulk, reducing both
the costs of buying and selling. Large businesses have bargaining
advantages and are accorded a preferential treatment by the firms they
deal with.

Larger firms have better credibility and can offer better security, making
them a better risk for lenders thus reducing interest rates and financing
costs.
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(b) Oligopoly:
An industry dominated by a few large suppliers is called Oligopoly.
Advantages of oligopoly:
(i) Members of an oligopoly might be able to set prices (though this might be
illegal).
(ii) Oligopolists are able to make large profits as there are few players in the
market.
(iii) Barriers to entry allow an oligopolist to maintain profits in the long term.
(iv) Customers are easily able to make price comparisons among the few
players existing in the market and chose the best alternative.
Disadvantages of oligopoly:
(i) Price setting in an oligopoly might prove disadvantageous to customers.
(ii) Innovation of small players in the industry is stifled.
(iii) An oligopolist is able to make good profits on an on-going basis so there
may be no incentive for product improvement.
(iv) Oligopolistic industries can suffer from price wars.
Ans.5 (i) (c) Equity

(ii) (b) producing similar products
(iii) (c) 30
(iv) (d) A rise in the price of the normal good
(v) (d) Constant returns to scale
(vi) (b) The marginal efficiency of capital
(vii) (d) Stable economic growth
(viii) (a) Stagflation
(ix) (b) Regressive
(x) (b) inflation and unemployment
(xi) (c) planned investment reacts to changes in the interest rate
(xii) (d) All of the above
(xiii) (c) Quota
(xiv) (b) call in loans and increase reserves
(xv) (a) exports will become less competitive
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SECTION B
Ans.6 (a) Nominal interest rate:

Nominal interest rate is the actual interest rate paid on any borrowing.
For instance if a borrower pays Rs. 10 on every 100 rupees lent to him. The
nominal interest rate is 10%.
Real interest rate:

The real interest rate is the one that is inflation adjusted. It is so named because
it states the real rate/(benefit) that the lender would receive after it has been
adjusted for the effect of inflation.
For instance; if a bond compounds annually and has a nominal interest rate of
10% and the inflation rate is 6% then the real interest rate is only 4%.
(b) Open-Market Operations:

The central bank may reduce the level of aggregate demand in the economy
using open market operations in the following way:
(i) By selling government bonds from its portfolio of reserves.

(ii) The bonds are sold to dealers in government bonds, who then resell them
to commercial banks, and other financial institutions.
(iii) The commercial banks pay for these bonds to the central bank reducing
the balance of reserves that the commercial banks hold with them.
(iv) When the cash reserves of a commercial bank drop, then the level of
demand deposits that it can take drops by a magnitude of the money
multiplier.
(v) Consequently, the level of money supply tightens, and aggregate demand
declines.
Ans.7 (a) Inflation:

Inflation means the expansion of money supply in excess of the amount justified
by the state of the trade, resulting in a general rise in prices.
Harmful effects:
(i) Increase in cost of living:
Due to inflation, cost of living rises, the working classes are hard hit.
Wages do not rise at the rate prices are rising. Those sections of society
who have fixed incomes, like salaried class, face difficulty in buying their
daily needs.
(ii) Inequality in income distribution increases:

When prices are rising, business men and big landlords make huge money
and the distribution of income among various classes of society becomes
more unequal. The position of wage earners becomes weaker. So the gap
between rich and the poor increases.
(iii) Decreases in saving:

During rising prices the savings of common people are adversely affected.
Greater part of their incomes is used to buy consumer goods.
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(iv) Less exports and more imports:

If rate of inflation in a country is higher than its major trading partners, its
exports will become relatively more expensive and imports relatively
cheap. As a result, the balance of trade will suffer, affecting employment in
export industries and in industries producing import-substitutes.
(b) Even when the labour market is in equilibrium, there is a level of unemployment
in the economy which is unavoidable. This is known as the natural rate of
unemployment.
Diagrammatically, this has been shown below:
In the above diagram, real wage rate is measured on the y-axis and
employment of labour on x-axis. Where, D(L) is the demand curve, S(L) is supply
curve. The “workforce” includes those who are actively supplying their labour, as
well as those who are voluntarily unemployed.
L1 shows the equilibrium between the supply and demand for labour at the wage
level W 1.
L2-L1 workers in the workforce choose not to partake at a given wage level.
These people are those who make up the level of natural unemployment in the
economy.
Ans.8 (a) Economic growth:

Economic growth is a long-term expansion of a country’s production potential.
Benefits of Growth:
Following are benefits of economics growth:
(i) Higher Employment/lower unemployment
Real economic growth gives rise to higher employment. This is because
with higher levels of output, firms tend to employ more workers.
(ii) Increased tax revenues

Growth boosts the government finances by way of taxes that in turn help to
reduce the budget deficit.
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(iii) Enterprise confidence

Sustained economic development casts a positive impact on company
profits and raises business confidence.
(iv) Increased per capita income and improved living standards

Sustainable economic development improves the living standards of the
community, reduces poverty and raises per capita income.
(v) Higher investment

Economic growth induces demand that in turn leads to higher level of
investments due to the likelihood of more profits.
(vi) Social welfare

Increased economic growth provides more resources to the Government
as well as NGOs to carry out welfare activities.
(b) The multiplier is :
1 ÷ [1 − (0.7 − 0.2)] = 1 ÷ 5 = 2
Therefore, the new equilibrium level of national income will be:
(50,000,000 × 2) + 100,000,000 = Rs. 200,000,000
Ans.9 (a) Money market:

It is the financial market for raising short-term credit.
Instruments of money market:

(i) Treasury bills:
These are instruments issued by government to raise money from the
public. T-bills have short maturities, and the government will pay the holder
the par value when this maturity is up. They are bought through auction,
and are one of the most popular instruments because they are considered
almost risk-free because they have the backing of the government.
(ii) Certificates of Deposits:

These are time deposit with a commercial bank, whereby after a fixed time
a certain level of money will be returned to the holder. This has a slightly
higher yield because the default risk is higher with a bank, than with the
government.
(b) Functions of money:

There are four functions that money undertakes in modern society:
(i) To act as a medium of exchange:

Allowing economic agents to exchange goods without the need to barter.

Allowing people to compare the relative price of goods and services
through a common denomination.

Allowing people to forgo immediate consumption if they have surplus
resources, and to retrieve it at a later date for consumption.
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(iv) To act as a standard of deferred payments:

Allows people to consume goods and services in the current time period,
whilst continuing to pay in future periods.
(c) The equation for velocity of circulation of money as per quantity theory of money
is as follows:
M×V=P×Y
Where:
M is the money supply = Rs. 12,926 billion

V is the velocity of circulation of money =?
P is the average price level = 1.8
Y is the real value of national output = Rs. 28,726 billion
Therefore, in the given situation 12,926 × V = 1.8 × 28,726 or V = 4
Ans.10 (a) The items which are excluded from the computation of national income under
the income method are:
(i) Transfer Payments (e.g. state pension, unemployment benefits and other
social payments) which are ignored to avoid double counting the income:
 when the original household earns it prior to it being taxed.

 when the household receiving the transfer payment receives it from
the government.
(ii) Income gained from stock appreciation. This is due to inflation and not a
rise in output.
(iii) Private transfers of cash from one person to another.
(iv) Income not declared to the tax authorities (the “black” or “shadow”
economy).
(v) Activity such as subsistence farming and barter transactions.
(b) Equilibrium of AS and AD:

The equilibrium of aggregate supply (AS) and aggregate demand (AD) under
neo-classical approach is illustrated below:
In the above diagram, price level is measured on y-axis and real national output
on x-axis. AD is the aggregate demand curve whereas LRAS is the long run
aggregate supply and SRAS is the short run aggregate supply curve.
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The macro economy is in equilibrium at the point where SRAS (value of output
produced within an economy) is equal to AD (level of demand for goods and
services).
The reason why equilibrium does not arise at the intersection of LRAS and AD
is that LRAS is the productive potential in the economy. Whereas SRAS is what
is actually being supplied in the macro economy, and is therefore what
equilibrium should be based upon.
If the general price level is above the equilibrium point, then firms will
persistently find that their stocks remain unsold. This then indicates that they
should cut back on further production, to reduce the level of inventory.
If, however, the general price level is below the equilibrium point, then demand
will outstrip supply, stocks will quickly become run down, thus signaling to
producers that they should increase supply.
These mechanisms ensure that the macro economy is restored to equilibrium.
Ans.11 (a) Functions of public finance:

According to Musgraves, the major functions of public finance are the following:
(i) Allocative function

The allocative function refers to the role of government that it plays in
providing resources to extend support to the public goods. The examples
include expenditure on infrastructure, national defence, etc.
The budgetary policy divides the total resources among private and social
goods by which the mix of social goods is chosen.
(ii) Distributive function

The government plays the distributive role by way of deciding as to whom
the resources should be allocated. Practically it means setting the balance
between free market outcomes and distribution through taxes and other
means with a view to reducing economic inequalities and yielding optimal
income distribution.
(iii) Stabilization function

Stabilization refers to the overall role of ensuring economic stability
through monetary and fiscal policies.
(b) Limitations of fiscal policy:

Following are the limitations of fiscal policy:
(i) Forecasting
The fiscal policy is devised around predictions of various economic
activities. For the fiscal policy to work as desired, these predictions need
to be accurate. However, the coming events of economic instability
cannot be predicted accurately.
(ii) Time lag

Time lag means the difference between the time the action is taken and
the time when the fiscal measure has its impact felt.
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Ans.12 Concept of ‘J curve’ in correcting the current account deficit:

J curve refers to the trend of a country’s trade balance following a devaluation or
depreciation under a certain set of assumptions.
Exchange rate depreciation is one of the strategies to redress a current account

deficit. Depreciation of the exchange rate is expected to make imports more
expensive and exports relatively cheaper, hence correcting the deficit. However, in
doing so, the deficit may get worse in the short run before improving. This situation is
depicted by J curve as shown below:
Assuming that the economy starts at point A. Following devaluation, the deficit
increases before it swings up to a surplus with the passage of time. The reason for the
deficit is the time lag and elasticity of demand and supply. Producers and consumers
will take time to adjust to the currency change. Supply may be inelastic in the short run
as producers may have already entered into contracts and not be able to respond to
the price changes. Thus export revenues may not immediately increase. However,
imports may become more costly and demand for them may be relatively inelastic,
thus increasing the deficit.
(THE END)
Page 10 of 10

Section A
Q.1 (a) Explain the concept of Production Possibility Curve (PPC) with the help of a diagram. (07)
(b) Briefly discuss how the concept of PPC is useful in explaining the economic concept
of ‘scarcity’. (03)
Q.2 (a) Define Price Elasticity of Demand. Identify and briefly explain the factors which
determine the Price Elasticity of Demand. (06)
(b) Compute the price elasticity of a product if an increase in the price of the product from
Rs. 10 per unit to Rs. 11 per unit causes a decrease in its demand from 2.5 million
units to 1.9 million units. (03)
Q.3 The following data refers to the total revenue and total costs of a firm at various output
levels:
Output (units in million) 0 1 2 3 4 5 6 7 8 9

Marginal revenue (Rs. in million) - 12 12 12 11 11 10 10 10 9
Total costs (Rs. in million) 22 28 32 35 36 37 40 44 54 65
(a) Calculate the firm’s fixed cost and the marginal cost at each level of output. (03)
(b) Determine the level of output at which the firm would optimise its profits. Also
determine the amount of profit that the firm will make at the desired level of output. (05)
Q.4 What do you understand by the term Perfect Competition? With the help of an appropriate
diagram, explain the Equilibrium of a Firm under perfect competition in the long run. (08)
(i) Which of the following would reduce inflation?

(a) Increase in government spending
(b) Increase in direct taxes
(c) Increase in indirect taxes
(ii) A devaluation of the currency will normally result in:

(a) a reduction in the current account deficit
(b) an increased level of economic activity
(c) a reduction in the domestic cost of living
(d) both (a) and (b)
(iii) Which of the following will always increase when a manufacturing business increases
its output?
(a) Fixed costs
(b) Marginal cost
(c) Total costs
(d) Average variable cost
(iv) Central banks can act as lenders of last resort because:

(a) they have the ability to create money
(b) they are the only financial institution that is legally allowed to make loans
during financial crises
(c) it provides consulting services to commercial banks whenever they find
themselves in financial difficulty
(v) In the short run, a firm would stop production if:

(a) marginal cost was equal to marginal revenue
(b) total revenues were less than total variable costs
(c) total costs were equal to total revenues
(d) total revenues were less than total fixed costs
(vi) Which of the following situations would cause the value of the multiplier to fall?
(a) A fall in the level of government expenditure
(b) A rise in the marginal propensity to consume
(c) A rise in the marginal propensity to save
(d) A fall in business investment
(vii) Which of the following does not normally happen in the recession phase of the
business cycle?
(a) A fall in the level of national output
(b) A rise in the rate of inflation
(c) A rise in the level of unemployment
(viii) Diseconomies of scale occur when:

(a) long run average costs begin to rise
(b) short run average costs begin to rise
(c) long run average costs begin to fall
(d) short run average costs begin to fall
(ix) Demand curve slopes downward because of:

(a) consumer indifference
(b) elasticity of demand
(c) inelastic demand
(d) law of diminishing marginal utility
(x) Which of the following is the example of price discrimination?

(a) Peak and off-peak call charges
(b) A doctor charging higher consultancy fees in posh area
(c) Business and economy class flights
(xi) Which of the following constitute(s) injection into the circular flow of income?
(a) Investments by businesses
(b) Government expenditures on goods and services
(c) The value of exports
(xii) The following data relates to the economy of a country during a one year period:
Rs. in billion
Exports 288
Investment 166
Savings 117
Government expenditure 150
Imports 335
Taxes 199
The national income of this economy ________ during the year.

(a) falls
(b) rises
(c) remains static
(d) is in equilibrium
(xiii) If a government were to pursue an expansionary monetary policy it would:

(a) raise interest rates and sell securities
(b) lower interest rates and sell securities
(c) raise interest rates and buy securities
(d) lower interest rates and buy securities
(xiv) Which of the following is the main distinguishing factor between capital and money
markets?
(a) Transaction costs
(b) The amounts involved
(c) Time to maturity
(d) Risk involved
(xv) Which of the following is the advantage of floating exchange rates?

(a) Avoids damaging speculation against the currency
(b) Avoids the need for government intervention in the foreign exchange markets
(c) There is no need to hold reserves
Section B
Q.6 (a) Discuss the concept of Consumer Price Index (CPI). State any three limitations of
CPI as a measure of inflation. (06)
(b) Briefly discuss any two measures that may be adopted for controlling inflation if an
economy is facing:
cost-push inflation
demand-pull inflation (04)
Q.7 (a) List any four functions of a central bank. (02)
(b) Explain how the central banks are able to reduce the level of aggregate demand in an
economy by changing the reserve requirements of commercial banks? (08)
Q.8 (a) Identify and briefly explain the different phases of business cycle. (06)
(b) List any eight indicators which would confirm the stages of business cycle the
economy is in. (04)
Q.9 (a) What is meant by ‘direct taxation’ and ‘indirect taxation’? Give two examples of each
type of taxation. (04)
(b) State any three advantages and three disadvantages of direct and indirect taxation. (06)
Q.10 (a) Discuss gross investment and explain its relevance to the accelerator principle. (03)
(b) Consider the following information and determine the rate of change of gross
investment for each of the following five years (year 1 to 5) using the accelerator
principle based on the following data:
Capital output ratio is 4:1

Depreciation is 10% of previous year’s capital
Output details for the five years are as follows:
Year 0 1 2 3 4 5
Output (in billion) 200 200 240 280 320 320 (07)
Q.11 (a) Define capital market and list any four types of organizations that operate in the
capital market. (04)
(b) If a government wishes to raise money through the capital market, explain the choice
of instruments that are available to it. Also state what matters it would consider while
raising the money through capital market. (06)
Q.12 (a) Briefly discuss five main causes of disequilibrium in the balance of payments. (05)
(b) State and briefly describe the impact of any five measures that a government may take
to rectify the disequilibrium in the balance of payments. (05)
(THE END)
Suggested Answers
SECTION-A
A.1 (a) The Production Possibility Curve (PPC) represents all possible combinations of alternative
goods an economy can produce with the available resources within the given state of
technology.
For the purpose of simplicity the curve is based on two products only i.e. X and Y and we
assume that all the resources are allocated for producing the two goods only.
The diagram is shown below:
The curve indicates that the economy can produce a number of combinations such as 60
units of X and 100 units of Y or 90 units of X and 60 units of Y and so on.
The cost of an item measured in terms of the alternatives forgone is called its opportunity
cost. Thus, if an economy produces 60 units of X and 100 units of Y (point H) instead of
producing 90 units of X and 60 units of Y (point J), then the opportunity cost of producing
(100-60) more units of Y would be the lost production of (90-60) units of X.
If the economy produces lesser quantities, it would not be utilizing the full resources
whereas quantities in excess of those represented by the curve cannot be produced on
account of limited resources.
(b) Since scarcity forces an economy to forego one choice for another, PPC is useful in
explaining how choices can be made and the ways in which the scarce resources may be
allocated towards achieving the optimal production. PPC can also be used to show how
change in the long run affects the resources that are available in the economy.
A.2 (a) Price elasticity of demand is the measure of the responsiveness of the quantity demanded of
a product to any changes in its price.
Determinants of Price Elasticity of Demand:

A number of factors determine the price elasticity of demand:
(i) Substitutes: More the substitutes, the higher the price elasticity, as people can easily
switch from one good to another if a minor price change is made.
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(ii) Percentage/ratio of income: The higher ratio of the product’s price to the consumers’
income, the higher is the elasticity, as people are careful while purchasing the good.
(iii) Necessity/nature of commodity: The more necessary a product is, the lower the
elasticity of demand, as people will buy it no matter what the price is, such as
medicine, wheat etc.
(iv) Time/Emergency: Elasticity of demand is higher in the long run, as more and more
people stop demanding the good if high price persists.
(v) Goods having several uses:
Certain goods have different uses e.g. electricity is a necessity for certain uses, while
for other uses it is a comfort or luxury. Elasticity will be measured depending upon
the use. More important the use is more inelastic the demand would be and less
important the use is, more elastic the demand would be.
(vi) Durable Goods and perishable goods:

Sometime, demand elasticity is determined on the basis whether a good is durable or
perishable. For example if there is a very high rise in prices, demand for motor cars,
deep freezers, air conditioners can be postponed while perishable goods like fresh
milk, vegetables and fruit etc. have inelastic demand as their use cannot be postponed.
(vii) Consumer’s Loyalty:

Some firms try to make their customers more and more brand loyal by excessive and
persuasive advertisement. Their advertisement activities help them to develop habits
of their brand. For example branded cellular phones and tablets.
(b) Method 1
P1  Rs.10, P2  Rs.11
Q1  2,500,000, Q2  1,900,000
Change in Demand Q1  Q 2
We know that Price Elasticity of Demand (PED) =

Average Demand Q Q  / 2
 1 2
Change in Price P1  P2
Average Price P1  P2  / 2
Change in Demand = Q1 – Q2 = 2,500,000 – 1,900,000 = 600,000
Q1 Q 2 2,500,000  1,900,000
Here, Average Demand    2,200,000
2 2
Change in Price = P1 – P2 = 10 – 11 = –1
P1  P2 10  11
Average Price    10.5
2 2
600,000 1
 PED  
2,200,000 10.5
600,000  10.5
  2.86
- 2,200,000
Ignoring the –ve sign PED = 2.86
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A.3 (a) Fixed costs have to be paid even when output is zero and no production is taking place.
The firm's fixed costs are therefore Rs. 22 million at zero output.
Marginal cost at each level of output is given in Annexure A.
(b) The firm aims to maximize profits and it will do this where the marginal revenue gained
from selling the last unit is equal to the marginal cost of producing that unit. The only
output level where marginal revenue equals marginal cost is 8 million units, where both
MR and MC are Rs. 10 million [Refer to Annexure A for working]. The firm will thus
produce 8 million units.
Profit equals total revenue minus total cost. At 8 million units this is Rs. 88 million  Rs. 54
million = 34 million.
Annexure A
Output Costs MC MR Revenue
Units in million -------------------- Rs. in million --------------------
0 22 - 0 0
1 28 6 12 12
2 32 4 12 24
3 35 3 12 36
4 36 1 11 47
5 37 1 11 58
6 40 3 10 68
7 44 4 10 78
8 54 10 10 88
9 65 11 9 97
A.4 In perfect competition every purchaser and seller is so small relative to the entire market that he
cannot influence the market price by increasing or decreasing his purchases or output.
The equilibrium of a firm under perfect competition and in the long run is depicted by the
following diagram:
Under perfect competition the same price prevails in the market and hence sale of each additional
unit produces the same revenue and therefore MR=AR=P(Price). MC is the marginal cost curve
which depicts the increase in cost on account of production of each additional unit. With the sale
of each additional unit the total profit of the firm would increase till such time that the MC
remains below the Marginal Revenue Curve i.e. PL. The profit will be maximum when the MC
curve cuts PL from below because after this point each additional unit will cost more than the
revenue it would generate. At this stage Marginal Cost would be equal to Marginal Revenue and
the firm would be producing OM units.
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In the long run, the firms are able to increase /decrease their output by varying their equipment.
Therefore, in the long run no firm in a position to earn super normal profits. If price increases and
the firms start earning super profits, other firms enter the market or existing firms increase their
output. If price decreases and there are below normal profits, firms exit the market.
A.5 (i) (b) Increase in direct taxes

(ii) (d) both (a) and (b)
(iii) (c) total costs
(iv) (a) they have the ability to create money
(v) (b) total revenue were less than total variable cost
(vi) (c) a rise in the marginal propensity to save
(vii) (b) a rise in the rate of inflation
(viii) (a) long run average costs begin to rise
(ix) (d) law of diminishing marginal utility
(x) (d) both (a) and (b)
(xi) (d) all of the above
(xii) (a) falls
(xiii) (d) lower interest rates and buy securities
(xiv) (c) time to maturity
(xv) (b) avoids the need for government intervention in the foreign exchange markets
SECTION-B
A.6 (a) Consumer price index (CPI) is a measure of the weighted average of prices of a basket of
goods and services. It is calculated by taking price changes for each item in the
predetermined basket, averaging them, and then weighing them based on the importance of
each.
If the price of bread increases from Rs.150 to Rs.165 (10%) then the new price in indexed
terms would be 110. The reason that the items are “weighted” is that certain goods and
services are said to contribute to the cost of living more than others.
Limitations of CPI as a measure for inflation:

 It is not fully representative because of different spending habits.
 Price increases may be due to difference in quality of goods and services.
 Selection of base year may be quiet arbitrary.
(b) Measures to control inflation when an economy facing cost-push inflation:
 Limit wage increases:

Wages can be significant input costs, and by keeping wages low, this will assist in
reducing the upward pressure on final prices.
 Limit cost of utilities:

Another significant input cost is energy, and the government can reduce the increase of
these prices to temper inflation.
 Reduce cost of imports:

This can be done by allowing the domestic currency to appreciate in relation to the
currency it is importing from, thereby reducing the costs of domestic firms.
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Measures to control inflation when an economy facing demand-pull inflation:
 Raise interest rates:

This will reduce consumers’ real disposable income, and hence they will spend less.
 Raise taxes to reduce disposable incomes and spending:

This could include increasing a Value Added Tax (i.e. a tax associated with buying
goods) to discourage spending.
 Reduce money supply:

By removing money from circulation, the central authority reduces the ability for
transactions to occur, thereby reducing the potential for prices to rise.
A.7 (a) Functions of the central bank

Following are the functions of the central bank:
 Sole supplier of currency
 Banker to the government:
 Banker to the banks
 Lender of last resort
 Exchange rate controls
 Clearing agent
 Establish specialised banks
(b) The central banks are able to reduce the level of aggregate demand in an economy by
changing the reserve requirements, as described hereunder:
(i) When a central bank increases the level of reserves that the commercial banks must
hold, the commercial banks have to reduce the level of loans that they give out.
(ii) A certain reduction in the level of reserves that commercial banks must hold
translates, through the multiplier effect, in a much bigger contraction in the overall
money that they loan out. This causes the money supply to decline.
(iii) As the money supply contracts, money becomes “tight” (i.e. less available and more
expensive). This reduced level of money in the economy raises the interest rate, and
reduces the amount of credit available in the economy. Consequently interest rates
rise and firm individuals looking for investment are discouraged from borrowing, and
spending more money.
(iv) The effect of tight money reduces the level of aggregate demand, causing a drop in
output, employment and inflation.
A.8 (a) Phase of business cycles are as follows:

 Prosperity (Boom period)
The economy is expanding, which means output, income, employment, prices and
profits increase. At this phase, banks issue credit more freely which facilitates firms to
invest in increasing output to meet the demands of consumers with higher income. A
growing economy also means that there may be inflationary pressures, caused by high
demand, and insufficient levels of output.
 Downturn
In this phase, economic activity begins to slow down. When demand begins to
decrease, firms begin to scale down their production and investment plans. There is a
steady decline in output, profits, prices and employment as demand falls, and firms
respond by reducing their output. Banks reduce the credit that they issue, firms cancel
orders that they place, and people begin to lose their jobs, which further decreases the
level of aggregate demand.
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 Depression
With high unemployment levels, low incomes, low consumer demand and low
investment, the economy slips into a state where output remains very low. There is
under-utilisation of resources. Business confidence is extremely low, as profits and
prices go lower and lower.
 Recovery
At this stage, there is an increase in levels of economic activity as demand begins to
increase slightly. With an increase in demand, production increases, causing an
increase in investment. This causes a steady rise in output, incomes and business
confidence. Assets in the economy begin to be utilised again, and levels of GNP start to
increase.
(b) Indicators of business cycle that confirms at which stage the economy is:
 Leading economic indicators
 Index of business confidence
 Manufacturers’ new orders
 New building permits for private housing
 Money supply
 Coincident economic indicators

 Number of people in employment
 Industrial production
 Personal incomes
 Manufacturing and trade sales
 Lagging economic indicators

 Consumer Price Index (i.e. level of inflation)
 Average duration of unemployment
 Interest rates
 Average income
A.9 (a) Direct taxation:

A tax paid directly to the government by the person on whom it was imposed.
Example:
 Income tax
 Inheritance tax
 Capital gains tax
 Wealth tax
 Property tax
Indirect taxation:
A tax that increases the price of a good, meaning that the impact of tax is passed on to the
buyer/consumer.
Examples:
 Sales tax
 Custom duty
 Excise duty
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(b) Advantages of direct taxation:

 Equitable: people with higher incomes pay more to the society than those with less
income, creating a more equitable distribution of (net) wealth.
 Cost of collection is low: it is an economical way of raising revenues, saving expense.
 Relative certainty: the government can estimate how much it will receive allowing
better planning of projects.
 Flexible: if a government needs to raise revenues quickly, it can do so by raising the
rate of direct taxes.
Disadvantages of direct taxation:

 Possible to evade: it is possible to falsify tax claims meaning the correct amount is not
always paid.
 Unpopular: the end user will often try to find ways to avoid paying it.
 Discourage savings/ investment: if too high, then it would leave consumers and firms
less money to put to other causes and larger investor would explore investment outside
the country.
Advantages of indirect taxation:

 Change the pattern of demand: the government can alter the demand for a product
(say, alcohol or cigarettes).
 Can correct externalities: if a product causes direct external costs (e.g. health costs
associated with alcohol or cigarettes), the tax can be used to mitigate these.
 Less easy to avoid: often these are part of the final price, ensuring collection of taxes.
 Allows people greater choice: consumers make choices and then tax is paid, rather
than having income taken away immediately.
Disadvantages of indirect taxation:

 Increases inequality: regardless of their incomes, people are faced with the same tax on
a good.
 Causes cost-push inflation: increases the price of inputs for goods.
 Establish a “black market”: if taxes make prices too high, can incentivize people to
source the goods from alternate (sometimes illegal) markets.
 Higher uncertainty: if people buy less goods during recession, then this means the
revenue received will decrease much more.
 Distorts the market: it can lead to disequilibrium in the market for products that have
been taxed.
A.10 (a) The amount of investment required for all new investment plus the amount required to
service the fall in value of existing capital
The accelerator principle asserts that investment levels in an economy are positively related
to a change in the rate of GDP
Page 7 of 9
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In order to meet the fixed capital output ratio, a firm needs to invest in new capital and also
cover the depreciation of capital from the previous year.
(b) Output Capital Net Depreciation Gross

% change in
Year gross
(in billion) (4:1) investment 10% Investment
investment
0 (800)
1 200 800 0 80 80 0.00%
2 240 960 160 80 240 200.00%
3 280 1,120 160 96 256 6.67%
4 320 1,280 160 112 272 6.25%
5 320 1,280 0 128 128 -52.94%
A.11 (a) Capital market is the financial market which is largely used to raise long-term finance and
capital.
The main types of organisations that operate in the capital markets are as follows:
 Corporations
 Commercial banks
 Stock exchanges
 Investors
 Non-bank institutions (insurance companies/leasing companies/mortgage banks etc.)
(b) The way in which a government would raise money through the capital markets by issuing
the following instruments:
 Debentures: A debt instrument where there is no physical asset for use as collateral.
Instead, the government’s creditworthiness is considered by investors to adjudicate the
risk involved.
 Bonds: The investors buy debt from the government in exchange for a fixed return at
various points of time, and then the principal (amount paid for it).
The matters which the government may consider while raising money from capital markets
are:
 Rate of interest that needs to be paid to investors
 Length of time to pay back
 The risk factor of them not returning money to investors
 Alternative methods of raising capital (increasing taxes, etc.)
A.12 (a) Following are some of the causes of disequilibrium in balance of payment:
Natural factors
Natural calamities like drought or flood may easily cause disequilibrium in balance of
payments. These natural calamities can adversely affect agricultural and industrial
production. Exports may decline and imports may go up, causing a deficit in the country’s
balance of payment.
Trade cycles
Business fluctuations caused by the operation of trade cycles may also result in
disequilibrium in country’s balance of payments. For instance, if there occurs a recession, it
may induce a fall in the exports and exchange earning of the country concerned resulting in
a disequilibrium in the balance of payments.
Page 8 of 9
Suggested Answers
Political instability
Political instability results in disrupting the productive potential within the country, thereby
causing a decline in exports.
Relatively high rate of inflation
High rate of inflation as compared to other countries makes the goods produced by that
country relatively expensive. As a result, its exports decline and the balance of payment
runs into a deficit.
Trade restrictions by other countries
Sometimes other countries impose heavy custom duties or fix quotas or ban imports from a
country. It results in lower exports of that country.
Inelastic demand for machinery and industrial goods
The demand for these goods by less developed countries is inelastic because these less
developed countries have no choice since there is shortage of such goods in these countries
and to increase their growth rate they are going to need such goods. Hence their imports
remain high.
(b) The following measures are usually taken to correct a disequilibrium in the Balance of
Payments:
(i) Depreciation or devaluation of the home currency which makes the imports costlier
and uncompetitive, whereas exports become more competitive.
(ii) Protectionist measures resulting in either partial restriction or complete ban on
imports or increase in cost of imports.
(iii) Domestic deflation by reducing the supply of money and thereby aggregate
domestic demand so that the quantity of imported goods decreases.
(iv) Increase in domestic interest rate to attract deposits from foreign countries.
(v) Import substitution to reduce the overall quantity of imports.
(vi) Exchange control regulations to restrict outflows of funds from the home country.
(vii) Stimulating exports by providing subsidies and tax holidays to export-oriented
industries.
(THE END)
Page 9 of 9

Section A
Q.1 Free market economy permits private ownership and control of factors of production.
However, it is argued that it often results in exploitation of weak economic agents because
of which government has to intervene to control and regulate the economy in several ways.
In the light of above, explain the role of government in a mixed economy. (06)
Q.2 Explain the law of variable proportions. Discuss the various stages of law of variable
proportions with the help of a diagram (schedule not required). Also explain at which stage
a rational producer would stop production. (10)
Q.3 (a) One of the characteristics of a monopolist is the ability to engage in price
discrimination. Describe the term ‘Price Discrimination’. Briefly explain the conditions
which must exist to enable the monopolist to exercise the power of price discrimination
effectively. (04)
(b) Monopolist will be in equilibrium at that price-output level at which his profits are
maximized. Explain the price-output equilibrium of a monopolist with the help of a
diagram. (08)
Q.4 (a) What do you understand by ‘Change in Quantity Supplied’ and ‘Change in Supply’? (02)
(b) Briefly explain any five factors that are responsible for ‘Change in Supply’. (05)
(i) The demand curve for the product of a firm operating under conditions of perfect
competition would be:
(a) identical to the marginal revenue
(b) intersecting the marginal revenue curve at the point where marginal cost is equal
to marginal revenue
(c) intersecting the average variable cost curve at its lowest point
(d) perfectly inelastic
(ii) Shahid has employed 25 workers to whom he pays wages at the rate of Rs. 150 per
day. He is now intending to increase the wage rate of all workers by Rs. 20 per day in
order to attract one additional worker. Given that all other costs remain constant, the
marginal cost of labour per day would be:
(a) Rs. 20 (b) Rs. 170 (c) Rs. 670 (d) Rs. 4,420
(iii) Farhan has fixed income which he spends on only two goods i.e. X and Y. Farhan’s
total utility will be maximized when he distributes his total income in a manner that:
(a) average utility of last unit of X purchased is equal to the average utility of last
unit of Y purchased
(b) marginal cost of last unit of X is equal to marginal cost of last unit of Y
(c) total utility of good X is equal to the total utility of good Y
(d) marginal utility of last unit of X purchased is equal to the marginal utility of last
unit of Y purchased
(iv) The level of structural unemployment would most likely be reduced by:
(a) increase in the level of consumer expenditure
(b) increase in research and development grants for technology
(c) increase in labour mobility
(v) Which of the following represents a withdrawal from the circular flow of national
income?
(a) A rise in consumption
(b) A deficit on the balance of trade
(c) A surplus on the balance of trade
(d) A rise in public investment
(vi) If there is an increase in investment in an economy by Rs. 250 million and marginal
propensity to consume is 3/4, then overall effect on the total output of the economy
would be:
(a) Rs. 1,000 million (b) Rs. 333.33 million
(c) Rs. 187.50 million (d) Rs. 750 million
(vii) Mohsin pays income tax of Rs. 2,500 on his earnings of Rs. 20,000. Danish pays
Rs. 4,000 income tax on his earnings of Rs. 32,000. Kinza pays Rs. 5,000 income tax
on her earnings of Rs. 40,000. The income tax system is:
(a) regressive (b) proportional (c) progressive (d) equitable
(viii) Which of the following is correct?

(a) People with low incomes have higher average propensity to spend
(b) National income is said to be in an equilibrium when planned withdrawals from
circular flow of national income are equal to planned injections into circular
flow of national income
(c) People with high incomes have higher average propensity to spend
(ix) Balance of payments surplus is balanced by:

(a) buying gold or other foreign reserves
(b) paying off debts
(c) selling gold or other foreign reserves
(x) Which of the following is an example of contractionary monetary policy?

(a) A decrease in spending on infrastructure
(b) An increase in direct taxes
(c) An increase in interest rates
(d) A decrease in reserve to be maintained with central bank
(xi) Which of the following cannot be used as a tool to correct balance of payments
disequilibrium?
(a) Floating exchange rate
(b) Fixed exchange rate
(c) Domestic interest rate
(d) Buying / selling of domestic currency by central bank
(xii) In an economy where demand for imports is price inelastic and demand for exports is
price elastic, an appreciation in the value of domestic currency would result in:
(a) increase in imports spending and decrease in exports revenue
(b) increase in exports revenue and decrease in imports spending
(c) increase in imports spending as well as exports revenue
(d) decrease in imports spending as well as exports revenue
(xiii) The instrument that may be issued by government in capital market to raise money
for a long-term investment is:
(a) certificate of deposits (b) commercial paper
(c) preference shares (d) bonds
(xiv) The production possibility frontier is concave to the origin because:

(a) in order to produce one good, resources must be diverted from the other
(b) some resources are better at producing one good and some resources are good at
producing other good
(c) there is always some level of unemployment
(d) all resources contribute towards production equally
(xv) In which of the following options consumer sovereignty is in the order of highest to
lowest?
(a) Market economy, mixed economy, planned economy
(b) Mixed economy, market economy, planned economy
(c) Market economy, planned economy, mixed economy
(d) None of the above
Section B
Q.6 (a) The following data relates to the economy of a country over a one year period:
Rs. in billion
Domestic consumption 230,000
Taxes on expenditures 69,000
Government expenditures 51,750
Capital formation 58,650
Exports 80,500
Imports 74,750
Subsidy 5,750
Net property income from abroad 4,750
Capital depreciation 23,000
You are required to compute the following:

(i) Gross Domestic Product (GDP) at market price and at factor cost (03)
(ii) Gross National Product (GNP) at market price and at factor cost (02)
(iii) Net National Product (NNP) at market price and at factor cost (02)
(Show all necessary workings)
(b) Identify any six types of difficulties that are commonly faced in measuring National
Income. (03)
Q.7 (a) What do you understand by the term ‘Multiplier’? With the help of a diagram show
the multiplier effect of an increase in investment by Rs. 100 million on the equilibrium
level of income where marginal propensity to save is 1/3. (06)
(b) Briefly explain any four measures by which government may influence the level of
private investment in an economy. (04)
Q.8 (a) Define Phillips Curve. Explain the trade-off between unemployment and wage
inflation with the help of a Phillips Curve. (08)
(b) Describe the type of unemployment that is generally observed during a period of
recession in an economy. (02)
Q.9 (a) Governments often seek to achieve certain objectives by influencing the exchange
rates. Identify any three such objectives. (03)
(b) Governments often follow a policy of deliberately weakening the domestic currency
by reducing its parity value within a fixed rate system. Identify the purpose of
following such policy and also discuss the factors upon which effectiveness of such
policy depends. (07)
Q.10 (a) Commercial banks play a vital role in creation of credit money in an economy.
Describe the process of credit creation by commercial banks by means of advancing
loans, with the help of an example. (06)
(b) Briefly discuss any four factors which might limit the commercial banks’ ability to
create credit money in an economy. (04)
Q.11 (a) What do you understand by ‘Terms of Trade’? Briefly explain whether improved
terms of trade always mean a fall in the balance of payments deficit. (04)
(b) Briefly explain various monetary and non-monetary measures which may be taken by
the government to correct balance of payments deficit. (06)
Q.12 Briefly describe any two features of each of the following:

(i) An economy in a period of downturn (ii) Good taxation system
(iii) Derivative instruments (iv) Mutual funds
(v) Investment banks (10)
(THE END)
Suggested Answers
A.1 In a mixed economy, government plays an important role to overcome the inadequacies of free
market economy. It includes:
(i) Distribution of income

In order to correct the unequal distribution of income and wealth that may exist under free
market system, government needs to reallocate income in an economy. Quite often this
involves raising taxes on high earners or luxury items and spending them on providing
facilities for general public.
(ii) Price control

To restrain the monopolies that may exploit consumers by charging exorbitant prices under
free market economy, government sometimes acts to control prices for certain essential
goods and services, either by becoming the supplier for such commodities or imposing
strict regulations on suppliers.
(iii) Production of merit goods

Government might act to ensure a minimum level of supply of merit goods and services by
introducing subsidies when there is a lack of incentive for suppliers to produce the desired
quantity.
(iv) Controls through law

The government regulates and controls commercial activity to prevent possible excesses or
shortages that might occur in a completely free market due to manipulation by influential
traders and manufactures etc.
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A.2 According to the law of variable proportions, when more and more units of variable factor of
production (labour) are applied, holding the quantities of fixed factor of production (capital/land)
constant, marginal product (MP), average product (AP) and total product (TP) would continue to
increase up to a certain point after which the MP, AP and TP would start to decrease and finally
becomes negative.
The stages of law of variable proportions can be explained with the help of following diagram:
Stage I:
In this stage, AP is maximum (R) whereas TP increases initially at increasing rate (L) and
thereafter it increases at diminishing rate (L to M). MP also increases initially and reaches its
maximum (N) however, later on it begins to diminish and becomes equal to AP (O). In this stage
MP exceeds or is equal to AP.
Stage II:
In this stage, TP continues to increase at diminishing rate and reaches its maximum point (G).
Correspondingly MP diminishes rapidly and becomes zero (C). AP starts from its maximum (R)
and thereafter it begins to decrease. In this stage, MP is less than AP.
Stage III:
In this stage, TP starts diminishing, AP also continues to decline and MP turns negative thus law
of variable proportions firmly manifests itself.
A rational producer will not opt to stop production at Stage I because his fixed factor will remain
underutilized and he will be foregoing the opportunity of increasing production by increasing the
quantity of the variable factor whose average product continues to rise throughout in Stage I. He
will also not choose Stage III where not only average product is falling but also the total product
is falling and marginal product is negative. He would opt to produce in Stage II, where the
marginal product continues to remain positive. The producer will employ the variable factor up
to the point where marginal product equals to marginal cost.
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A.3 (a) Price discrimination can be described as the action of selling the same product to different
groups of buyers at different prices in order to maximize profits.
Conditions required for price discrimination:

(i) Control over price:
Monopolist must be able to control the price to be able to set different prices of the
good.
(ii) Price elasticity of demand:

Monopolist must be able to identify different group of buyers having different price
elasticity of demand. Prices may be increased where price elasticity of demand is low
i.e. buyers are willing and able to pay higher prices for the same good with
considerably lesser impact on demand.
(iii) Segregation of markets:

It means that the buyer in one market may not have an easy access or willingness to
approach another market. Price discrimination would not be effective if buyers in one
market can easily purchase goods from the other market where price is lower.
(b) AR = Average revenue

AC = Average cost
MC = Marginal cost
MR = Marginal revenue
It can be seen from the above diagram that up till OQ output, marginal revenue (MR) is
greater than marginal cost (MC) but beyond OQ the MR is less than MC. Therefore, the
monopolist will be in equilibrium at the output OQ where MR is equal to MC and profits
are the greatest.
The price at which output OQ is sold in the market can be known from looking at AR.
Corresponding to equilibrium output OQ, the price on the AR is QP′ = OP. Thus, given
the cost-revenue situation, the monopolist will be in equilibrium at the output OQ and will
be charging price equal to QP′ = OP.
Thus, the total profit earned by the monopolist in the equilibrium position is equal to the
rectangle P′LCP i.e. the shaded area.
Page 3 of 10
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A.4 When the supply of a commodity changes due to a change in its price, it is said to be a change in
(a) quantity supplied. It is represented by the movements on the same supply curve. When supply of
a commodity changes due to change in non-price factor, it is said to be a change in supply. It is
represented by the shifting of supply curve from its original place.
(b) Factors responsible for change in supply:

(i) Costs of resources used
If the prices of the factors used in production rises, then in order to produce the same
quantity of output, the price to be charged must increase. Different prices may be applicable
to different output levels. In this case the price would increase for each quantity/(level) of
output, and therefore the supply curve would shift accordingly.
(ii) Imposition of indirect taxes or subsidies

Imposition of an indirect tax will increase the cost of product as supplier will attempt to
pass on the incidence to consumer and thus price would rise. Similarly, government can
stimulate the supply in a certain industry by granting a subsidy. Subsidy would reduce the
cost of production of the suppliers which would encourage them to increase the supply.
(iii) Price of substitutes in production

A rise in the price of a substitute in production will cause a decrease in supply of the good
under examination as substitute product would become more attractive for producers who
would divert their resources accordingly.
(iv) Price of complements in production

A rise in the price of a complement in production will lead to an increase in supply of the
good under examination as such goods would become more attractive for producers who
would increase the supply accordingly.
(v) State of technology

A change in state of technology may shift the supply curve. An improvement in technology
would increase efficiency which would cause an increase in supply.
A.5 (i) (a) identical to the marginal revenue

(ii) (c) Rs. 670
(iii) (d) marginal utility of last unit of X purchased is equal to the marginal utility of last unit
of Y purchased
(iv) (c) increase in labour mobility
(v) (b) A deficit on the balance of trade
(vi) (a) Rs. 1,000 million
(vii) (b) proportional
(viii) (d) Both (a) and (b)
(ix) (d) both (a) and (b)
(x) (c) An increase in interest rates
(xi) (b) Fixed exchange rate
(xii) (d) both imports spending and exports revenue will decrease
(xiii) (d) bonds
(xiv) (b) some resources are better at producing one good and some resources are good at
producing other good
(xv) (a) market economy, mixed economy, planned economy
Page 4 of 10
Suggested Answers
A.6 (a) (i) GDP at market price Rs. in billion

Domestic consumption 230,000
Government expenditures 51,750
Capital formation 58,650
Total expenditures 340,400
Add: Exports 80,500
Less: Imports (74,750)
(A) 346,150
GDP at factor cost

GDP at market price [computed in (A)] 346,150
Less: Taxes on expenditure (69,000)
Add: Subsidy 5,750
(B) 282,900
(ii) GNP at market price
GDP at market price [computed in (A)] 346,150
Add: Net property income from abroad 4,750
(C) 350,900
GNP at factor cost
GDP at factor cost [computed in (B)] 282,900
Net property income from abroad 4,750
(D) 287,650
(iii) NNP at market price
GNP at market price [computed in (C)] 350,900
Less: Capital depreciation (23,000)
327,900
NNP at factor cost
GNP at factor costs [computed in (D)] 287,650
Less: Capital depreciation (23,000)
264,650
(b) Difficulties faced in measuring national income:

(i) Non-monetized transactions such as services of housewives and agricultural
products used by farmers for own consumption are generally not considered while
measuring the national income.
(ii) The barter transactions may either be totally ignored or included on the basis of
approximation.
(iii) Income of foreign firms creates complications i.e. whether to include it in national
income of the country of operation or country of origin.
(iv) Collection, compilation and analysis of statistical data is a highly technical exercise
and availability of sufficient trained staff is often difficult.
(v) Due to illiteracy, many producers are not able to keep reliable data of their
production.
(vi) A significant component of economic activity relates to black economy and is often
ignored in such calculations.
(vii) Due to lack of proper documentation and adequate statistical data there is always a
danger of double counting on not counting of income.
(viii) There is always a problem with regard to the treatment of the government
expenditure in national income such as whether to include or exclude administration
expenses, social welfare expenditure, payment of interest on national debt etc.
Page 5 of 10
Suggested Answers
A.7 (a) Multiplier can be explained as the ratio of change in income to change in investment.
In the above diagram, SS is the saving curve and II is the investment curve. These two
curves intersect at point E and hence, the equilibrium level of income is determined. If now
there is an increase in investment by Rs. 100 million, then II curve will shift to the position
of I’I’ and the two curves I’I’ and SS will intersect at point E’ which would be the new
equilibrium level of income. Hence, the diagram shows that an increase in investment by
Rs. 100 million would increase the national income by Rs. 300 million (1 ÷ MPS × change
in investment). Thus the value of multiplier is equal to 3.
(b) The government may influence the level of private investment in an economy by taking
any or combination of the following measures:
(i) Control interest rates
By altering the interest rates, government may influence the level of private
investment in an economy. If intention is to encourage higher volume of
investments, interest rates are reduced and vice versa.
(ii) Provide direct encouragement to investing firms
By offering investment grants, perhaps directed at particular region, by lowering the
cost of investment i.e. cost of doing business, by improving the rule of law, by
providing tax incentives etc. government may stimulate the level of private
investment in an economy.
(iii) Technological developments
Government may encourage technological developments by financing research
schemes of its own as well as those of private firms which may inspire the level of
private investment in an economy as well.
(iv) Business confidence
In order to influence the level of private investment, government may stimulate the
business confidence by pursuing an economic policy for continued growth consistent
with the stated goals.
(v) Volume of consumption
Government by following specific policy may affect the volume of consumption
which would affect the level of investment in an economy. For instance, by
regulating money supply government may influence the volume of consumption
which would affect investment levels with the influence of the accelerator.
(vi) Government spending
By increasing or lowering government spending, government may influence the level
of private investment. For example, expenditure on infrastructure would create
demand which may stimulate the investment from private sector.
Page 6 of 10
Suggested Answers
A.8 (a) According to the Phillips Curve (PC), there is a trade-off between unemployment and wage
inflation i.e. when unemployment falls, labour shortages may begin to occur resulting in
skilled labour to be in a position to put an upward pressure on wages. On the other hand, at
high levels of unemployment, labour does not have the bargaining power to increase their
wages; therefore, wage inflation is likely to stay low. This relationship can further be
explained with the help of PC diagram:
At point A, the rate of unemployment is U1 and wage inflation rate is W1. As rate of
unemployment reduces from U1 to U2, wage inflation rate increases from W1 to W2 i.e.
point B on PC. It can be seen that as resources are near full capacity, demand for labour is
high therefore enabling them to demand high wages. On the contrary, when
unemployment rate increases from U1 to U3, wage inflation reduces from W1 to W3 i.e.
point C on PC which indicates that there is a spare capacity in the economy, labour is in
excess supply and ready to work at low wages to a level where wage inflation may even be
negative.
(b) When an economy is in a recession or in a period of low growth, demand-deficient /

cyclical unemployment is generally observed i.e. aggregate demand is less than the
potential output in an economy. Firms therefore cutback production to cut costs and / or
maintain profits in the process thus reducing the amount of labour that is required.
Page 7 of 10
Suggested Answers
A.9 (a) Governments often seek to influence the exchange rates to achieve following objectives:
(i) To stabilize the currency against the pressures of short-term speculations.
(ii) To provide greater stability and protection to domestic producers by restricting the
competition from foreign traders.
(iii) To stimulate demand for exports or to reduce imports thus correcting the
disequilibrium in balance of payments.
(b) The purpose of following a policy of currency devaluation is to boost exports by making
them economical and more competitive in a global market while discouraging the imports
by making them more expensive thus balance of payments deficit improved.
The effectiveness of following a policy of devaluation is dependent on:
(i) Price elasticity of demand for imports
If the demand for imported goods and services is inelastic then a rise in the price of
imports will not significantly reduce the volume demanded. It would however,
increase total expenditure on imports thus deepening the deficit. Demand for
imports may be price inelastic due to:
 Firmly entrenched preferences for overseas goods
 Lack of flexibility of domestic firms to replace imports
 Dependence on imported raw materials and other essential items
(ii) Price elasticity of demand for exports

If demand for exported goods and services is price inelastic then a fall in their price
will not significantly increase the volume demanded. It would however, reduce total
income from exports and deepen the deficit. Demand for exports may be price
inelastic due to:
 Poor perceived quality of exports
 Lack of flexibility of domestic firms to take advantage of export demand
A.10 (a) The process of credit creation by commercial banks by means of advancing loans can be
understood with the help of following example:
Example
Assume that bank A receives a deposit of Rs. 100 from a customer. It would lend say Rs.
80 to another customer after accounting for reserve requirement (assuming 20% in our
example). The borrower would draw a cheque of Rs. 80 i.e. the entire amount of the loan
and give it to someone who would deposit it in bank B.
Bank B after satisfying the required reserve ratio would generate a loan of Rs. 64. Second
borrower would draw a cheque of Rs. 64 for the entire amount of the loan and give it to
some other person who would deposit it in bank C.
This process continues and banking system is able to create money supply of around Rs.
400 from the initial deposit of Rs. 100 as shown hereunder:
Maximum deposit creation = (Initial deposit – reserve) × Monetary multiplier

Whereas monetary multiplier = 1 ÷ Reserve percentage
Therefore, the maximum deposit creation in our example = (100 – 20) × 1÷20%
= Rs. 400/-
Page 8 of 10
Suggested Answers
(b) The following factors may affect the commercial banks’ ability to credit creation in an
economy:
(i) Total amount of cash
The amount of credit is dependent on the initial size of the money supply. The larger
the total amount of available cash, the more credit can be created and vice versa.
(ii) Size of reserve ratio
If reserve ratio requirement is high, less amount of money would be available with
banks for lending and there would be less credit creation.
(iii) Liquidity preferences
How much cash people want to hold? If say, there is high inflation, then people may
not wish to hold their money in banks where the real value is set to diminish thus
reducing the ability of commercial banks to create credit money.
(iv) Central bank policies
The central bank may limit the commercial banks’ credit creation ability by means of
monetary policy. It may utilize a number of instruments (for e.g. open market
operations) to control credit money in an economy.
(v) Availability of quality securities
Banks do not issue credit to everyone. They would only grant credit if they can
receive a high value asset in return from the borrower. If this is not possible, then
credit may not be created.
(vi) Lack of investment opportunities
In a period of downturn or recession, the demand for credit would be reduced
significantly as investors might not be willing to avail credit facilities.
A.11 (a) It is the ratio of export prices to import prices.

The terms of trade are said to improve when prices of a country’s exports rise relative to the
prices of its imports as it may now receive more imports for each unit of goods exported.
Improving terms of trade do not necessarily result in a fall in the balance of payments
deficit. This is because the terms of trade refer to prices whereas the balance of payments
takes both prices and quantities into account. For example, an improvement in terms of
trade caused by an increase in the price of exports may bring about a proportionately
greater fall in the demand for exports leading to a worsening of the balance of payments
situation.
(b) Monetary measures

(i) Exchange rate depreciation
Reducing the rate of exchange of domestic currency in terms of foreign currency
would make the imports costlier and uncompetitive, whereas exports become more
competitive.
(ii) Deflation
A decline in the price level domestically may increase the attractiveness of domestic
goods on the international market, thereby increasing exports.
(iii) Exchange control
In an extreme situation, by restricting access to foreign exchange, the central bank
can control the level of imports.
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Non-monetary measures
(i) Tariffs
These are duties placed upon imports. They increase the price of imports, making
them less attractive to the domestic market.
(ii) Quotas
A government may fix the maximum quantity or value of a commodity to be
imported during a given period. By restricting imports through the quota system, the
deficit may be reduced and balance of payments position be improved.
(iii) Export promotion
A government may promote domestic goods and services on the international
market through organizing exhibitions and trade fairs as well as striking diplomatic
deals.
(iv) Import substitution
A country can reduce the level of imports by becoming more self-reliant and
producing these goods and services domestically. This can be done by providing
specialist training, subsidies and tax concessions.
A.12 (i) An economy in a period of downturn:

 Demand for goods and services begin to decline forcing the firms to begin scaling back
their production and investment plans.
 There is a steady decline in output, profits, prices and employment as demand falls and
firms respond by reducing their output.
 Banks start declining the credit, firms cancel or postpone the placement of orders and
people begin to lose their job which further decreases the level of aggregate demand.
(ii) Good taxation system:

 A good taxation system raises revenue for government without creating negative
distortions in the economy, such as disincentives to work and investment.
 It should be equitable i.e. taxes should be levied in accordance with one’s ability to
pay.
 It should be based on a principle of benefit i.e. a principle whereby people should pay
taxes based upon the utility they gain from its implementation.
(iii) Derivative instruments:

 Derivative is an instrument whose price is dependent on one or more underlying
asset(s).
 It is merely a contract between two parties and traded either over the counter or on an
exchange.
(iv) Mutual funds:

 It is an investment vehicle where many investors pool their resources together to be
invested in a variety of financial instruments.
 It allows individual investors to participate (invest) in a well-constructed diversified
portfolio which may not be probable for an investor with small sum of capital.
 The investor is entitled to buy or sell his share (units) at the net asset value of the fund.
(v) Investment banks:

 Investment banks acts as financial intermediaries between issuers and investors.
 Investment banks do not accept deposits. They undertake a number of financial
services for their clients such as by underwriting shares and providing advisory services
in merger, acquisition and restructuring transactions etc.
(THE END)
Page 10 of 10

Section A
Q.1 In view of the scarcity of means and the multiplicity of ends, the economic problem lies in
making the best possible use of resources to get maximum satisfaction. Briefly discuss how
resources are allocated under different economic systems to optimize their use. (06)
Q.2 (a) (i) The quantity demanded for Alpha decreases from 300 units to 250 units, when
the price of Beta increases from Rs. 50 to Rs. 55.
(ii) The quantity demanded for Gamma increases from 400 units to 450 units, when
the price of Delta increases from Rs. 100 to Rs. 125.
For each of the above cases, you are required to:

determine the Cross Price Elasticity of Demand (XED) and (04)
on the basis of XED determined above, comment on whether the goods are
substitutes or complements. (04)
(b) State why firms need to know XED of their products. (03)
Q.3 State and explain the law of Equi-Marginal Utility with the help of a diagram, assuming
there are only two commodities i.e. A and B and the consumer has limited income at his
disposal. (08)
Q.4 (a) Oligopoly is the situation where industry is dominated by a few large suppliers. Briefly
discuss any six features of oligopoly. (06)
(b) When oligopolists fix prices by collusion among themselves, they are known as cartel.
Discuss the factors that are responsible for the success / failure of price cartel. (04)
(i) During the year, a flood destroyed significant portion of agricultural land used to
produce rice. What would be the short-run effect on supply diagram for rice?
(a) A movement down the existing supply curve
(b) A movement up the existing supply curve
(c) A shift to the right of the supply curve
(d) A shift to the left of the supply curve
(ii) Islamic mode of financing includes an arrangement in which a person participates with
his money and another with his efforts/expertise. This mode of financing is known as:
(a) Ijara (b) Mudaraba (c) Musharaka (d) Murabaha
(iii) Demand for cars decrease when their prices increase. However, demand may also
decrease when income of consumers decrease. Price and income elasticities of cars are
said to be:
(a) elastic; negative (b) elastic; positive
(c) inelastic; negative (d) inelastic; positive
(iv) The production possibility curve would move inwards when:

(a) there is a change in consumer taste
(b) there is an increase in employment of skilled labour
(c) there is a depletion of natural resources
(v) Which of the following statement is correct with respect to relationship between the
average cost curve and marginal cost?
(a) Average cost curve will slope downwards when marginal cost is less than average
cost
(b) Average cost curve will slope upwards when marginal cost is less than average
cost
(c) Average cost curve will slope downwards when marginal cost is more than
average cost
(d) There is no direct relationship between average cost curve and marginal cost
(vi) A Pakistani resident makes an investment in a company resident in United States. This
transaction will be recorded in Pakistan as:
(a) credit in current account (b) debit in current account
(c) credit in capital account (d) debit in capital account
(vii) Preference shares enjoy certain privileges over ordinary shares. Which of the following
is NOT a privilege of preference shares?
(a) First right to dividend
(b) Greater voting rights
(c) First right to assets in the event of liquidation of a company
(d) Both (b) and (c)
(viii) Demand for imports may be price inelastic due to:

(a) high dependence on imports
(b) firmly entrenched preferences for imported goods
(c) lack of flexibility of domestic firms to replace imports
(ix) Which of the following would NOT lead to inflation?

(a) Increase in money supply (b) Increase in interest rate
(c) Increase in tax exemptions (d) Exchange rate depreciation
(x) The basic concept which underlies the accelerator theory of investment is:
(a) investment depends on the level of savings
(b) investment is inversely related to the rate of interest
(c) investment is determined by the volume of commercial bank lending
(d) investment in an economy is a function of output
(xi) According to the Quantity Theory of Money, if the money supply is Rs. 125 million,
the average price level is Rs. 5 and national output is Rs. 300 million, the velocity of
circulation of money is:
(a) 4 (b) 8 (c) 12 (d) 16
(xii) Farhan lost his job when Orient Bank closed its operations in Karachi. He received
various offers but remained unemployed because he wanted a job in a bank only.
Farhan’s unemployment would be termed as:
(a) frictional unemployment (b) structural unemployment
(c) demand-deficient unemployment (d) seasonal unemployment
(xiii) The inflationary gap may only be bridged by:

(a) raising the government spending (b) raising the price level
(c) raising the output level (d) raising the employment level
(xiv) Which of the following instruments would be expected to give the lowest yield?
(a) Sovereign bonds (b) Corporate bonds
(c) Certificates of deposit (d) Shares
(xv) Consider the following with reference to circular flow of national income:
(A) subsidy on agricultural produce
(B) import of capital goods
(C) export of consumer goods
(D) levy of withholding tax
Which of the above represent injections into the circular flow of national income:
(a) (A) and (B) only (b) (B) and (D) only
(c) (A) and (C) only (d) (C) and (D) only
Section B
Q.6 (a) The rate of interest and marginal efficiency of capital (MEC) determine the level of
investment in an economy. Explain the relationship between rate of interest and MEC
(b) The MEC curve shifts outwards when expected rate of return increases. Briefly discuss
any three other factors that might cause an outward shift in MEC curve. (03)
Q.7 (a) There are various objectives of monetary policy but it is not possible to satisfy all of
them simultaneously. Briefly describe the conflicts that may exist between various
objectives of monetary policy. (06)
(b) Monetary policy may bring about many advantages but in the real economy, there are
certain limitations to its effectiveness. Discuss any four such limitations. (04)
Q.8 Output is determined where savings of all of the households in an economy are equal to the
desired investment opportunities. Explain the equilibrium between savings and investments
with the help of diagram. (10)
Q.9 (a) What do you understand by Demand-pull inflation and Cost-push inflation? (04)
(b) Briefly discuss the probable causes of Demand-pull inflation and Cost-push inflation. (06)
Q.10 (a) An important objective of a central bank is to reduce inflation. Briefly describe how the
central bank uses money market operations to achieve this objective. (03)
(b) What role does a central bank play for a government? (07)
Q.11 (a) Balance of payments is a combination of current account and capital/financial

account. Briefly discuss the components of:
current account
capital/financial account (08)
(b) List the ways through which government can promote the exports of a country in the
short-term. (02)
Q.12 (a) Frequent exchange rate variations may not be desirable. However, an absolute rigidity
of exchange rates in face of drastic changes may be equally harmful. Give arguments in
favour of floating exchange rates. (03)
(b) Indirect taxes are usually unavoidable and broaden the tax base. Specify the probable
advantages and disadvantages of indirect taxes. (07)
(THE END)
Suggested Answers
Ans.1 Allocation of resources to optimize their use under different economic systems is discussed as
follows:
(i) Planned economy:

In a planned economy, the decisions and choices about resource allocation are made by the
government. Money values are attached to resources and to goods and services, but it is the
government that decides what resources should be used, how much should be paid for
them, what goods should be made and what their price should be.
(ii) Market economy:

In a market economy, the decisions and choices about resource allocation are left to market
forces of demand and supply, and the working of the price mechanism. What producers
will make and what consumers will buy are kept in balance by price that producers will
want for their output and the price that consumers are willing to pay.
(iii) Mixed economy:

In a mixed economy, the decisions and choices about resource allocation are shared by
private sector and government. When private sector is unable to supply due to the absence
of appropriate profitability, government acts to ensure a minimum level of supply of such
commodities by introducing subsidies into a market. Similarly, government ensures that
supply of excess or unwanted commodities may not occur by imposing quotas.
Ans.2 (a) Determination of Cross Price Elasticity of Demand (XED)
( )
Where,
(i) XED (Alpha/Beta) = – 0.182(W-1) ÷ 0.095(W-2)

= – 1.916
W-1: % change in qd of Alpha

% change in qd of Alpha = (250 – 300) ÷ [(250 + 300) ÷ 2]
= – 0.182
W-2: % change in price of Beta

% change in price of Beta = (55 – 50) ÷ [(55 + 50) ÷ 2]
= 0.095
(ii) XED (Gamma/Delta) = 0.118(W-3) ÷ 0.222(W-4)

= 0.532
W-3: % change in qd of Gamma

% change in qd of Gamma = (450 – 400) ÷ [(400 + 450) ÷ 2]
= 0.118
W-4: % change in price of Delta

% change in price of Delta = (125 – 100) ÷ [(125 + 100) ÷ 2]
= 0.222
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Comment on whether the goods are substitute or complement

(i) Alpha and Beta are complements because of a negative cross price elasticity of
demand which indicates that when the price of Beta increases, the demand for Alpha
decreases. The coefficient is greater than one, indicating they are close complements.
(ii) Gamma and Delta are substitutes because of a positive cross price elasticity of
demand which indicates that when the price of Delta increases, the demand for
Gamma increases. The coefficient is less than one, indicating they are weak
substitutes.
(b) Information regarding XED is vital for firms when making production plans or setting price
of products. XED indicates the effect on demand for products due to change in price of
substitute or complement products. This knowledge allows the firms to develop strategies
to reduce their exposure to the risks associated with price changes by other firms, such as a
rise in the price of a complement or a fall in the price of a substitute.
Ans.3 According to the law of Equi-Marginal Utility, a consumer maximizes his total utility with his
limited income when marginal utility of the last rupee spent on each commodity is equal. This is
achieved at marginal rate of substitution i.e. marginal utility of A divided by marginal utility of B
is equal to price of A divided by price of B. This can be explained with the help of following
diagram:
In the above diagram, MN is the budget line representing the combination of two goods i.e. A
and B that the consumer can afford with limited income at his disposal. U, U 1 and U2 are various
indifference curves. An indifference curve that lies to the right of another represents a higher
value of satisfaction than the other. However, the budget line constrains the maximum utility
available to the consumer. Therefore, U1 is attainable, but inefficient whereas U2 is unattainable.
The consumer maximizes his total utility at a point on an indifference curve that is tangential to
the budget line. In above diagram, consumer maximizes his total utility at point O which is
tangent to budget line. Also, at point O, marginal utility per rupee spent on good A equals the
marginal utility per rupee spent on good B. At no other point could the consumer have a higher
utility given the constraints of the budget line.
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Ans.4 (a) Features of Oligopoly:
(i) Small number of large firms:

The oligopoly market is dominated by a small number of large firms with a high
concentration ratio. This characteristic gives each of the relatively large firm a
substantial market control.
(ii) Interdependence of firms:

It is the unique feature of oligopolistic market that the policies of every producer
directly affect others, because of less number of competitors and good substitute
products. Therefore pricing, output and other decisions of one firm generate prompt
response from the others.
(iii) Price rigidity:

Under oligopoly, firms avoid price competition for the fear of price war. They follow
the policy of price rigidity where prices tend to stay fixed irrespective of changes in
demand and supply conditions. No firm resorts to price-cut without making price-
output decision with other rival firms thus, leading to a monopoly under oligopoly.
(iv) Role of advertisement:

Due to non-price competition, oligopolistic firms employ various sales promotion
techniques to gain a greater market share. In view of this, firms have to spend
substantial amount on advertisement and other sales promotional activities.
(v) Indeterminate demand curve:

Under oligopoly the exact behavior pattern of a producer cannot be determined with
certainty. Any change in price by one firm may lead to change in price by the
competing firms, thus, demand curve keeps on shifting unlike monopoly and perfect
competition where demand curve is definite.
(vi) Barriers to entry:

Since oligopolistic market is dominated by small number of large firms, they may
create barriers for new entrants. Patents, economies of scale, control over essential
inputs, high capital requirements etc. may act as barriers for new firms.
(vii) Nature of product(s):

The firms under oligopoly may produce homogenous or differentiated product(s). If
firms produce homogenous products like cement or steel, they are known as perfect
oligopolies and if they produce differentiated products like automobiles, they are
known as imperfect oligopolies.
(b) The failure or success of price cartels under oligopolistic market depends on following
factors:
(i) Control on supply:

For the successful price cartel, firms under oligopolistic market must hold all or
substantial market share.
(ii) Close substitutes:

Success of price cartel depends on non-availability of close substitutes of product
otherwise when higher price is set by oligopolists, the buyers will shift their demand
to close substitutes.
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(iii) Price elasticity of demand:

Price cartel will be successful if price elasticity of demand for a product is inelastic.
Otherwise when oligopolists set higher price, buyers contract demand more
proportionately weakening the price cartel.
(iv) Agreement on individual share:

If all the firms in cartel agree on their allotted quota of supply, price cartels would be
successful. However, if firms secretly increase production and sale of the product,
price cartels would collapse because at increased supply, charging a higher agreed-on
price would not be possible.
(v) Competition law:

Price cartel would be affected by the presence / introduction of competition law. The
law prohibits firms to enter into an agreement that tend to lessen, distort or eliminate
competition within the market thus eliminating the price cartels.
Ans.5 (i) (d) A shift to the left of the supply curve

(ii) (b) Mudaraba
(iii) Removed for a second review
(iv) (c) there is a depletion of natural resources
(v) (a) Average cost curve will slope downwards when marginal cost is less than average cost
(vi) (d) debit in capital account
(vii) (b) Greater voting rights
(viii) (d) all of the above
(ix) (b) Increase in interest rate
(x) (d) investment in an economy is a function of output
(xi) (c) 12
(xii) (a) frictional unemployment
(xiii) (b) raising the price level
(xiv) (a) Sovereign bonds
(xv) (c) (A) and (C) only
Ans.6 (a) There is an inverse relationship between the rate of interest and marginal efficiency of
capital (MEC) i.e. higher the rate of interest, lower the MEC and vice versa. As long as the
MEC is greater than interest rate, firms will continue to invest. When MEC = rate of
interest, equilibrium investment is determined. Thereafter, investment would only increase,
when either the rate of interest falls or MEC rises.
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In above diagram, MEC curve represents the level of investment that will take place in the
economy at various levels of interest rate. At interest rate ro, investment Io is marginally
efficient i.e. has a net present value of 0 (or its internal rate of return equals rate of interest).
All points to the left of the MEC have a positive net present value. If the interest rate falls to
r1, then further investment would become feasible up to total investment I1 which is now
marginally efficient.
(b) The following other factors might cause an outward shift in MEC curve:
(i) Demand for product

If demand for particular product is expected to grow, it would induce the firms to
make investment thereby, shifting MEC curve to the right.
(ii) The state of confidence

If firms are optimistic about the favourable economic changes such as fall in costs,
they would expect the greater returns and be willing to make investments.
(iii) Technological development

Advances in technology and new inventions would make investment more
productive. Increase in productivity would cause the firms to invest more at a given
rate of interest thereby, MEC curve would shift outwards.
(iv) Government policy

The government policy as reflected by taxation or other regulations may affect
profitability of certain investments. Tax exemptions or subsidies may enhance the
profitability of firms which would shift the MEC outwards.
Ans.7 (a) The following conflicts may exist between various objectives of monetary policy:
(i) Price stability versus full employment

In order to increase employment, central bank takes various monetary policy
measures such as reducing interest rates. However, these measures could drive up
inflation, putting more pressure on the price stability target.
(ii) Economic growth versus exchange rate stability

In order to boost economic growth, a central bank may decide to depreciate local
currency to increase the likelihood of exports thus to achieve economic growth.
However, such act would jeopardize stability in exchange rates.
(iii) Economic growth versus credit control

A way to grow the economy might be through the expansion of credit, as it would
spur investment and spending. However, this comes with heightened economic risk of
credit defaulting.
(b) Following are the limitations of monetary policy:
(i) Existence of non-monetary sector

The existence of large non-monetized sector particularly in developing countries
hinders the operation of effective monetary policy as people at that sector (such as
rural areas) do not use money as medium of exchange rather barter is practiced.
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(ii) High liquidity in financial markets

Efforts of central bank to tighten the money supply would be adversely affected, if
agents in the economy have access to high liquid assets.
(iii) Time lags

The desired effects of a monetary policy often take time to occur. In order to be
effective, central bank would have to predict the circumstances in advance which are
difficult when there is high uncertainty.
(iv) Lack of co-ordination between monetary and fiscal policies

Monetary policy is implemented by central bank whereas fiscal policy is implemented
by the government. In the absence of co-ordination among the objectives of these
policies, the desired effectiveness would not be achieved.
Ans.8 The equilibrium between savings and investments with the help of diagram is explained as
follows:
The curve II indicates the intended investment levels which for the purpose of simplicity are
assumed to remain same at each level of GDP and therefore a horizontal line. The curve SS
represents saving levels that are primarily dependent on disposable income. In above diagram,
saving and investment curves intersect at point E. This point corresponds to a level of GDP given
at point M and represents equilibrium level of output in an economy. At this level of output, the
desired saving of households equals the desired investment of firms.
It is important to note that saving and investment would always tend to be in equilibrium in the
long-run. Whenever there is disequilibrium, the forces of demand and supply would bring them
back to an equilibrium position as explained below.
Consider point A, where desired saving of households is higher than the desired investment of
firms. Increase in savings mean decrease in consumption and consequent reduction in demand.
As a result, firms would cut back production and lay off workers until investments and savings
are in equilibrium and therefore, new output level would be determined.
Similarly consider point B, where desired saving of households is lower than the desired
investment of firms. In response to increased demand, firms would continue to increase
production and employ more workers until investment and saving are in equilibrium and
therefore, new output level would be determined.
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Ans.9 (a) Demand-pull inflation:

In demand-pull inflation, the aggregate demand for goods persistently exceeds their supply.
As the demand for goods is more than the total supply of goods at current price, there is a
tendency for increase in prices. Demand-pull inflation is generally observed in a situation of
full employment.
Cost-push inflation:
In cost-push inflation, the prices of goods rise due to persistent increase in the cost of
production of goods, while their demand remains consistent.
(b) Causes of Demand-pull inflation:
 Fiscal stimulus will increase aggregate demand in the economy. Given the effects of
multiplier, an increase in government spending would result in greater increase in
demand which would lead to demand-pull inflation.
 Monetary stimulus such as fall in interest rates, buying of government securities etc.
would trigger an increase in demand and may lead to a situation where ‘too much
money chasing too few goods’. The surplus demand would increase the price level
and therefore, demand-pull inflation.
Causes of Cost-push inflation:
 When level of unemployment in an economy is low, skilled labor would be in a

position to demand higher wages which would give rise to cost-push inflation.
 When people in an economy anticipate higher inflation, they may demand higher
wages to protect their real income. Higher wages would increase the costs to a firm
which would ultimately fulfill the expectation of higher inflation. When higher
inflation materializes, people expect it to be higher in the following period as well and
hence the chain of events continues. This is called the wage-price spiral.
 An increase in the price of raw materials and other inputs would give rise to cost-push
inflation. For example, imposition of indirect taxes would cause the higher costs to
firms which would ultimately pass on to end consumers resulting in cost-push
inflation.
 The exchange rate depreciation would make exports cheaper and imports more
expensive. In an economy where demand for imports is inelastic, exchange rate
depreciation would lead to cost-push inflation.
Ans.10 (a) Central bank can reduce inflation by contracting the money supply in an economy. Money
supply can be contracted by means of money market operations i.e. selling of government
securities. Purchase of securities by commercial banks would reduce the cash available with
them which would lead to decrease in investment and spending thus weakening the
inflationary pressure.
(b) Central bank plays the following role for a government:
 Issuer of currency:
The central bank has monopoly of issuing currency which is done keeping in view the
overall objectives within an economy.
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 Banker to the government:

The central bank offers advice and funding to the government for financing projects in
the same way a commercial bank would do to its customers.
 Regulator of the banks:

Central bank regulates the banks through banking laws and by means of monetary
policy instruments.
 Exchange rate controls:

The central bank has a control over country’s foreign currency reserves. It uses them
to overcome short-term exchange rate volatilities and inefficiencies.
 Establishment of specialized banks:

In some cases, central bank allows the creation of banks to serve a particular purpose,
usually not for commercial means. For example, agricultural bank to provide funds to
farmers at subsidized interest rates.
 Economic stability:
Central bank undertakes to ensure economic stability in a country. For example in
order to overcome inflationary pressure, it controls the money supply in an economy
by means of monetary policy.
Ans.11 (a) Components of current account:
(i) Trade in goods

This component includes import and export of tangible items such as finished goods,
semi-finished goods and component parts for assembly etc.
(ii) Trade in services

It includes intangible items such as tourism, financial services and consultancy etc.
(iii) Income
It comprises of overseas activity that leads to a flow of money back to the country.
For example, interest received from direct investment, the activities of subsidiaries
and dividends earned from owning shares in foreign firms etc.
(iv) Unilateral transfers

It includes receipts and payments that take place without anything receiving in return.
For example, donations, personal remittances, aid and grants etc.
Components of capital / financial account:
(i) Real foreign direct investment

It involves stable investments where investors are unlikely to pull their money at short
notice. For example, returns received by a domestic firm from a factory setup in
another country.
(ii) Portfolio investment

It involves acquiring interest such as shares in a business that has already been
established abroad. Such investors have little or no control over businesses.
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(iii) Financial derivatives

It involves dealing in foreign financial instruments; the underlying values of which are
based on other assets.
(iv) Reserve assets

These are financial assets that can be bought and sold by central authority such as
central bank and include a country’s official reserves of foreign exchange. For
example, central bank may use foreign financial assets to cover deficits and
imbalances.
(b) The ways through which government can promote the exports of a country in the short-
term:
(i) Organization of exhibitions and trade fairs to create awareness among overseas
importers.
(ii) Provision of tax rebates and other reforms to exporters.
(iii) Exchange rate control to ensure exports are not adversely affected by exchange rate
fluctuations.
(iv) Provision of finance at subsidized interest rates to exporters.
Ans.12 (a) Arguments in favor of floating exchange rates:
 The need for government intervention in the foreign exchange markets is eliminated
allowing its policy instruments to concentrate on internal issues such as
unemployment and inflation.
 It helps to correct balance of payments disequilibrium by free forces of demand and

supply of currency.
 Acts as a shock observer. Variations in the rates of exchange act as a check against
inflationary and deflationary forces.
(b) Advantages of indirect taxes:
 Indirect taxes can correct externalities. If a product causes direct external costs (e.g.
unwanted imports or products involve health costs associated with alcohol or
cigarettes etc.), indirect taxes can be used to mitigate them.
 Indirect taxes have wider coverage and are usually unavoidable. Being part of final
price of product, indirect taxes cannot be easily avoided.
 Unlike direct taxes which are charged against income, indirect taxes facilitate
consumers to make a choice by simply not consuming certain products.
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Disadvantages of indirect taxes:
 Indirect taxes are regressive. Every consumer of the taxed commodity pays the same
tax regardless of his/her income which promotes unequal distribution of wealth.
 The incidence of indirect taxes is inevitably passed on the consumers in the form of
increased prices which causes cost-push inflation.
 Indirect taxes may be uneconomical to collect as several intermediaries are involved

in the collection and the process involves a very large number of transactions that
may require close monitoring of the activities.
 Indirect taxes may be uncertain as it is not always possible to anticipate the collection
on account of tax imposed on a particular commodity.
 As indirect taxes are incorporated in the price of commodity, it may not promote
civic consciousness among tax payers as they might not feel the burden of taxes.
(THE END)
Page 10 of 10

Section A
Q.1 (a) What do you understand by the term “Production Possibility Curve” (PPC)? Why is
PPC downward sloping and concave to the origin? (04)
(b) Under what conditions would PPC shift outwards? (03)
Q.2 (a) Illustrate with the help of a diagram, how new equilibrium market price of a good is
achieved when price of substitute good increases. (06)
(b) List any four factors which are responsible for each of the following:
Change in demand (02)
Change in supply (02)
Q.3 (a) What do you understand by “economies of scale”? Briefly discuss any four factors that
contribute towards achievement of economies of scale. (07)
(b) Explain economies and diseconomies of scale with the help of long run average cost
curve. (04)
Q.4 (a) Explain the term equilibrium of the firm. (02)
(b) Briefly describe the reasons on account of which a firm under perfect competition acts
as a ‘price taker’ rather than a ‘price maker’. (05)
(i) Which of the following is a basic economic problem?

(a) Lower incomes and higher taxes
(b) Unemployment and inflation
(c) Unlimited wants and scarce resources
(d) Balance of payment deficits and recession
(ii) Which of the following is more likely to be found in a free market economy than in a
planned economy?
(a) An even distribution of wealth
(b) An incentive to innovate
(c) Production of goods for benefit of society as a whole
(d) Full employment of labour
(iii) A firm with existing sales of 1,000,000 units per annum is planning to increase the
price of a product from Rs. 100 to Rs. 120 per unit. If price elasticity of demand for
that product is 1.25, assuming no other changes, the sale of the firm after price
increase would be:
(a) 1,250,000 units
(b) 750,000 units
(c) 1,200,000 units
(d) 800,000 units
(iv) If the government sets the maximum price of a product below the market equilibrium
price, it would lead to:
(a) excess demand
(b) excess supply
(c) market equilibrium
(d) economies of scale
(v) Which of the following is not a characteristic of Indifference Curve (IC)?

(a) IC is negatively sloped
(b) Higher IC curve signifies higher level of utility
(c) IC is concave to the origin
(d) ICs cannot intersect each other
(vi) If marginal revenue is Rs. 50 and marginal cost is Rs. 40, the firm seeking profit
maximization would:
(a) increase price
(b) reduce output
(c) reduce price
(d) increase output
(vii) Which of the following is a tool of expansionary policy?

(a) Increase taxes
(b) Reduce subsidies
(c) Allow tax rebates
(d) Freeze wages
(viii) While pursuing contractionary monetary policy, the government would:

(a) raise interest rates and sell securities
(b) lower interest rates and sell securities
(c) raise interest rates and buy securities
(d) lower interest rates and buy securities
(ix) In a given economy, out of every additional Rs. 1,000 of national income, Rs. 200 is
taken in taxes, Rs. 100 is spent on imports and Rs. 500 is spent on domestically
produced goods. The multiplier is:
(a) 1.25
(b) 2
(c) 2.5
(d) 1.67
(x) Sales tax on food items is an example of:

(a) direct tax
(b) fixed tax
(c) progressive tax
(d) regressive tax
(xi) Net National Product (NNP) can be arrived at from Gross National Product (GNP)
by:
(a) deducting depreciation
(b) adding indirect taxes
(c) deducting indirect taxes and adding depreciation
(d) adding depreciation
(xii) Long Run Aggregate Supply (LRAS) curve is a vertical line because it is:
(a) dependent on price level and signifies the upper limit of the capacity in the
economy
(b) dependent on price level and signifies the lower limit of the capacity in the
economy
(c) independent of price level and signifies the upper limit of the capacity in the
economy
(d) independent of price level and signifies the lower limit of the capacity in the
economy
(xiii) Which of the following is a monetary measure for correcting the current account
deficit?
(a) Quotas
(b) Export promotion
(c) Import substitution
(d) Exchange rate depreciation
(xiv) The gilt edged market is regarded as the market for:

(a) stocks and shares
(b) derivatives
(c) high rated debt securities
(xv) The main difference between an investment bank and a commercial bank is that
investment bank:
(a) does not accept deposits
(b) does not underwrite shares
(c) does not assist companies in acquiring funds
(d) none of the above
Section B
Q.6 (a) Briefly describe three different approaches to measure National Income. (06)
(b) Differentiate between “Autonomous” and “Induced” investments. Give any two
examples of each. (04)
Q.7 (a) Discuss the Keynes’ Psychological Law of Consumption and the related propositions. (04)
(b) Briefly describe the determinants of consumption in an economy. (06)
Q.8 (a) Briefly explain the ‘Quantity Theory of Money’. (03)
(b) Identify three reasons why people prefer to hold money in liquid form. (03)
(c) Discuss how introduction of money has resulted in overcoming the shortcomings of
barter system. (04)
Q.9 (a) Distinguish between ‘Money Market’ and ‘Capital Market’. Identify any three
institutions which operate in each market. (06)
(b) Identify any two capital market instruments that are available to the government for
financing its expenditure. What factors the government should consider before raising
finances through these instruments? (04)
Q.10 (a) State the meaning of ‘Financial Intermediary’. (02)
(b) Describe the measures that are available to a central bank for restricting credit creation
ability of commercial banks. How such measures affect the process of credit creation? (08)
Q.11 (a) What do you understand by the term ‘Derivative’? List different ways in which
derivatives are traded. (03)
(b) Explain the following financial instruments:

(i) Call and Put Options (04)
(ii) Swaps (03)
Q.12 (a) Illustrate with the help of a diagram, the concept of deflationary gap in the economy. (04)
(b) Various sources of short-term and long-term credit are available to the firms. Briefly
discuss any two sources in each case. (06)
(THE END)
Suggested Answers
Ans.1 (a) The Production Possibility Curve (PPC) represents the maximum number of
combinations of two alternative goods an economy can produce with the available
resources within the given state of technology.
The reason for downward slope of PPC is that in order to increase the production of
one good, resources must be diverted from the production of other goods, hence
decreasing its output.
The PPC is concave to the origin because some of the resources in the economy are
more efficient at producing one type of goods and some are more efficient at
producing the other type of goods.
(b) Under the following conditions PPC would shift outwards:

 when there is an increase in resources available to the economy
 when there is an increase in efficiency
 when there is technological progress
Ans.2 (a) When price of a substitute good increases, the demand for the good under
consideration increases.
The following diagram shows how an increase in price of A affects equilibrium price
and equilibrium quantity of B:
Initially, equilibrium is at P0Q0. Increase in price of A causes an increase in demand

for B resulting in shifting of demand curve to right, from D to D’. Consumers are
now willing to buy Qd (point b) but producers are willing to sell only Q0 (point a).
This shortage of supply over demand (Qd-Q0) causes an upward pressure on the
price. As the price rises, the excess demand falls because quantity demanded
decreases while quantity supplied increases. The supply curve intersects the new
demand curve at point c, so the new equilibrium price is P1 (up from P0) and the new
equilibrium quantity is Q1 (up from Q0).
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(b) Factors responsible for:

 Change in demand
– Change in level of consumer income
– Change in price of substitutes
– Change in price of complements
– Change in tastes and preferences
– Expectations of price changes or shortages
– Change in the size of population
 Change in supply
– Change in cost of inputs
– Change in indirect taxes or subsidies
– Change in price of substitutes in production
– Change in price of complements in production
– Change in state of technology
Ans.3 (a) Economies of scale – Cost reductions achieved in case of / reduction in cost per unit
resulting from large scale production are known as economies of scale.
Factors that contribute towards achievement of economies of scale are as follows:

They arise from the fact that there is a mechanical advantage in the use of a
large machine as compared to many small machines.

These economies arise from the employment of specialized managers. They
also result from the delegation of routine and detailed matters to subordinates.
(iii) Commercial/Trading economies:

They arise from the purchase of materials in larger quantities. Large
businesses have bargaining advantages and are accorded a preferential
treatment by the firm they deal with.

These economies arise from the fact that a big firm has better credibility and
can borrow on more favourable terms.
(v) External economies:

External economies are those economies which accrue to each member firm
as a result of expansion of industry as a whole. Expansion of an industry may
lead to the availability of new and cheaper raw materials, tools and
machinery, and to the discovery and diffusion of a superior technical
knowledge.
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(b)
As the firm expands, it is able to take advantage of economies of scale because in the
long run, average cost falls. After a certain level of output is reached, all economies
of scale have been achieved and this point on the average cost curve is called
minimum efficient scale i.e. Qmes in diagram above. Further increase in output
beyond this point can result in the average cost per unit to rise, leading to
diseconomies of scale. These are often a result of managers/staff losing
control/motivation as production increases beyond a certain point.
Ans.4 (a) Equilibrium of the firm is the point at which the firm has no incentive either to
expand or contract its output. A firm would not change its level of output as it is
earning maximum profits at this point.
(b) On account of following reasons, the firm under perfect competition acts as ‘price
taker’ rather than ‘price maker’:
(i) Large number of buyers and sellers – under perfect competition, there are
large number of buyers and sellers, so no single buyer or seller is able to
influence the market price of the product.
(ii) Homogenous product – the products produced by all firms are standard or
identical under perfect competition which means no individual producer can
charge more for a good as none of the goods are superior in any way.
(iii) Free entry– under perfect competition, there is a free entry thus the existing
producers are not in a position to increase prices freely.
(iv) Perfect knowledge of price – the buyers and sellers are fully aware of the
price prevailing in the market and hence the same price prevails throughout
the market under perfect competition.
(v) Transport costs are zero or very insignificant – under perfect competition,
transport costs are negligible thus price discrimination at different locations is
not possible.
(vi) Perfect factor mobility – under perfect competition, factors of production are
perfectly mobile, hence no firm is in a position to manipulate price by
controlling factors of production.
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Ans.5 (i) (c) unlimited wants and scarce resources

(ii) (b) an incentive to innovate
(iii) (b) 750,000 units
(iv) (a) excess demand
(v) (c) IC is concave to the origin
(vi) (d) increase output
(vii) (c) allow tax rebates
(viii) (a) raise interest rates and sell securities
(ix) (b) 2
(x) (d) regressive tax
(xi) (a) deducting depreciation
(xii) (c) independent of price level and signifies the upper limit of the capacity in the
economy
(xiii) (d) exchange rate depreciation
(xiv) (c) high rated debt securities
(xv) (a) does not accept deposits
Ans.6 (a) (i) Expenditure approach :

This method arrives at national income by adding up all the expenditure
incurred on goods and services during the year.
The national income is calculated by summing up all the consumption and

the investment expenditure by individuals, corporations and the government
during the given period.
(ii) Income approach:

This method measures the national income after it has been distributed and
appears as income earned or received by individuals of the country.
In this method, national income is calculated by adding up the rent of land,

wages of employees, interest on capital and profit earned by
entrepreneurs/firms.
(iii) Production / output / value added approach:

In this method, the national income is found out by adding up total value of
final goods and services produced in a country during the year.
It is important to note that only ‘final’ goods and services are included. It does
not include intermediate goods because inclusion of intermediate goods
would result in double counting.
(b) Autonomous investment:

This type of investment is ordinarily undertaken by public bodies or private
organizations not pursuing profit.It is independent of the level of income and
aggregate demand. It is also independent of the profit it may bring, as it is not carried
out for that purpose.
Examples of autonomous investment:

(i) Construction of highways
(ii) Establishment of public healthcare centres
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Induced investment:
This type of investment is associated with private enterprises in pursuit of
maximizing profit. As the margin increases, more and more amount will be invested
until the economic gains no longer outweigh the costs. It is dependent on the level of
income.
Examples of induced investment:

(i) Investment by a company in a new project
(ii) Investment to expand a company’s existing warehouse facility
Ans.7 (a) According to Keynes Psychological Law of Consumption, people increase their
consumption as their income increases, but not by as much as their income
increases.
There are three propositions that can be inferred from this law:
(i) Aggregate consumption can increase due to increased aggregate income, but
the increase in aggregate consumption will be less than the increase in
income. This is because as basic necessities are fulfilled, people begin to save
additional income, hence savings increase.
(ii) What is not spent on consumption is saved.
(iii) The increase in income will lead to increased consumption or savings. It is not
possible for an increase in income to lead to a decrease in consumption and
savings.
(b) Determinants of consumption:

Following are the determinants of consumption in an economy:
(i) Real income:

Increase in real income would lead to increase in consumption and vice versa.
(ii) Distribution of income:

Change in pattern of income distribution would result in change of
consumption.
(iii) Expectations of price changes:

If prices are expected to rise, people will be motivated to spend more and
accumulate goods, hence increase in consumption.
(iv) Changes in fiscal policy:

Reduction in taxes would leave more post-tax incomes with the people and
this will stimulate higher expenditure on consumption.
(v) Changes in interest rates:

Decrease in interest rates would increase the amount of disposable income of
people and thus encourage consumption.
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Ans.8 (a) Quantity theory of money states that there is a direct relationship between changes in
the money supply and the rate of inflation. The theory is based on equation MV=PT.
goods and services sold in the same period which is PT. The equation is useful as an
explanation of inflation when certain assumptions are made and which, if accepted,
means that the average price level (P) is solely determined by changes in the money
supply (M).
(b) People prefer to hold money in liquid form due to the following reasons:
(i) To pay for goods and services.
(ii) To meet unforeseen circumstances.
(iii) To take advantage of market movements regarding future changes in the rate
of interest or bond prices.
(c) (i) To act as medium of exchange:

Barter system lacks the ability to exchange. Finding someone with opposite
needs is problematic in complex society. Money acts as a medium of
exchange by allowing economic agents to exchange goods without the need of
barter.

Fixing a measure across different types of products was complicated under
barter system. Money acts as a unit of account allowing people to compare
the relative prices of goods and services through a common denomination.

Barter system lacks the ability to store value, particularly when goods are
perishable. Money acts as a store of value allowing people to forgo immediate
consumption if they have surplus resources, and to retrieve it later.
Ans.9 (a) Following are the distinguishing features of money market and capital market:
Features Money market Capital market

Type of finance Debt instruments Equity instruments as well as
debt instruments
Maturity period Less than three months More than one year
Trading Between investors, bankers, Traded on stock exchange and
firms and government other secondary markets both
by institutions as well as
individuals.
Institutions that operate in money market:

(i) Governments
(ii) Mutual funds
(iii) Commercial banks
(iv) Discount houses
(v) Corporations
Institutions that operate in capital market:

(i) Corporations
(ii) Commercial banks
(iii) Non-bank institutions (insurance companies / mortgage banks)
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(b) The two main capital market instruments that are available to government are:
(i) Debentures/ Term Finance Certificates
(ii) Sovereign Bonds / Municipal Bonds
Factors which a government should consider before raising finances through

capital market:
 Rate of interest to be paid to investors.
 Length of time to pay back.
 Sources from which interest or principal would be paid.
 Alternative methods of raising capital (increasing taxes, etc.)
Ans.10 (a) Financial intermediary is an institution which links lenders with borrowers by
obtaining deposits from lenders and then re-lending them to borrowers. They provide
a link between savers and investors.
(b) Role of central bank to restrict the ability of commercial banks to create credit:
To control commercial banks credit creation ability, the central bank must be able to
control either directly or indirectly, the commercial banks liquidity position, upon
which their ability to create credit is based.
The following measures are available to a central bank to restrict the ability of
commercial banks to create credit:
(i) Open market operations:

The central bank can buy or sell government securities on the open market to
change the level of reserves that are held by commercial banks. The selling of
government securities would reduce the commercial banks’ cash reserves and
liquidity resulting in restraining credit creation.
(ii) Change reserve requirement:
Commercial banks are required to maintain a certain percentage of their
deposits with central bank as reserves. By increasing the level of reserves that
are required to be maintained by commercial banks, a central bank can restrict
the credit creation ability of commercial banks.
(iii) Bank rate / discount rate policy:

It is the rate at which a central bank lends money to and rediscounts the bills of
exchange presented by commercial banks. By increasing the bank rate / discount
rate, demand for credit from commercial banks would decline which would
restrict their ability to create credit.
(iv) Moral persuasion:
The central bank can issue non-obligatory directives to the commercial banks
to encourage them to increase or reduce credit creation.
Ans.11 (a) Derivative can be defined as an instrument whose price is dependent on one or more
underlying asset(s). It is a contract between two parties. The price of a derivative
changes with the change in underlying asset(s).
There are two main ways that derivatives can be traded i.e. over the counter (OTC)
and through an exchange.
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(b) (i) Call option:

It is an agreement which allows a person the option to buy an asset at a
certain price. If the price of the asset increases, then exercising a call option at
the (lower) predetermined price results in profit for the investors because they
are able to buy at a price which is lower than the prevailing price of the asset.
Put option:
It is an agreement which allows a person the option to sell an asset at a certain
price. If the price of the asset decreases, then exercising a put option results in
profit for the investors because they are able to sell at a price which is higher
than the prevailing price of the asset.
(ii) Swaps:
It is an agreement whereby the parties agree to exchange a series of cash flows
for a set period of time. Usually, at the time the contract is initiated, at least
one of these series of cash flows is determined by a random or uncertain
variable, such as an interest rate, foreign exchange rate, equity price or
commodity price. Often one party has ‘fixed’ rate, while the other has
‘floating’ rate. The exchange is done in view of market outlook or risk
appetite.
Ans.12 (a) When the equilibrium in the economy is at less than its production potential, there
exists a deflationary gap.
The deflationary gap can be explained with the help of following diagram:
OR
In the above diagram, short run aggregate supply is shown by the line SRAS and
aggregate demand by the line AD.
The actual level of national income is at the intersection of AD and SRAS i.e. at Ye
whereas Yf is the national income at full employment.
The gap between actual level of national income and national income at full
employment i.e. Ye and Yf is called a deflationary gap, as the price level is below of
what it would be with full employment in the economy.
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(b) Short-term sources of credit:
(i) Bank overdraft:

Under an overdraft arrangement, a business can withdraw cash from its bank
account beyond the available balance. Overdrafts do not have fixed
repayment period and mark-up is paid only when amount is overdrawn.
(ii) Trade credit:

Trade credit is usually allowed by suppliers of raw materials, components and
other goods and services in the normal course of trade. The term of credit is
generally for a period of 30-90 days. Trade credits are usually not subject to
mark-up.
(iii) Short-term loan:

It differs from bank overdrafts as there is a fixed repayment period and
therefore mark-up has to be paid whether the business requires funds at a
particular moment or not.
(iv) Bills of exchange:

It is a binding document. It binds borrowing party to pay a fixed sum of
money to lending party at a specified future date. Bill of exchange may or
may not be subject to mark-up charge.
(v) Promissory notes:
It is a financial instrument that contains a written promise by borrower to pay
a fixed sum of money to lender at specified future date. If may or may not
subject to markup charge.
Long-term sources of credit:
(i) Shares:
These are units of ownership in a financial asset, or corporation. They entitle
the holder to an equal distribution of future profit offered as dividend.
(ii) Debentures / Bonds:

These are debt instruments and may be issued at par, discount or premium.
There is usually a fixed repayment period, however, in some cases, options
for early redemption are given. These are subject to mark-up charge.
(iii) Long-term loans:

These are usually provided by banks. These are for a fixed period of time and
subject to mark-up charge.
(THE END)
Page 9 of 9


Section A
Q.1 (a) State the meaning of ‘price elasticity of supply’. Briefly discuss different types of
elasticity of supply. (05)
(b) Briefly explain the factors which determine the price elasticity of supply. (05)
Q.2 The following data refers to the revenue and costs (in million rupees) of a firm.
Output (units) 0 1 2 3 4 5 6 7 8
Total revenue - 50 100 150 200 250 300 350 400
Total costs 110 140 162 175 180 185 194 219 269
(a) Briefly explain the concept of fixed costs with reference to the above data. (02)
(b) Determine the marginal revenue at each level of output and interpret the results. (04)
(c) What level of output will the firm aim to produce and what would be the amount of
profit that the firm will make at this level? (04)
Q.3 Briefly discuss the important features of ‘Islamic economic system’. (08)
Q.4 (a) State the main features of monopoly and name any one organisation which operates
under monopoly. (03)
(b) Briefly explain the ‘monopolist’s equilibrium’ with the help of a schedule. (04)
(i) Which of the following is not an issue in macroeconomics?

(a) issues relating to balance of payment
(b) determination of prices in the agricultural sector
(c) relationship between inflation and unemployment
(d) possible effect of a budget deficit on the level of investment
(ii) If peas and beans are substitutes of each other, an increase in the price of peas will:
(a) increase the quantity of beans demanded
(b) increase the price of beans and the quantity sold
(c) decrease the quantity of peas sold
(iii) Period of a business cycle in which real GDP is increasing is called:

(a) recovery (b) downturn (c) recession (d) trough
(iv) ABC Limited employs 100 skilled workers at a wage rate of Rs. 2,800 per week. To
attract 10 more workers it raises the wage rate to Rs. 3,000 per week. The marginal
cost of employing the extra workers is:
(a) Rs. 20,000 (b) Rs. 30,000 (c) Rs. 50,000 (d) Rs. 200
(v) The financial market which is used to raise short term finance is called:
(a) capital market (b) money market
(c) derivative market (d) bond market
(vi) The main advantage of a mutual fund is that:

(a) it provides short term finance for investment in capital and money market
(b) it provides long term finance for investment in capital and money market
(c) it gives opportunity to investors to invest in a diversified portfolio
(vii) An investor who acquires a put option:

(a) buys the right to buy shares at a particular price
(b) buys the right to sell shares at a particular price
(c) sells the right to buy shares at a particular price
(d) sells the right to sell shares at a particular price
(viii) A deflationary gap exists in an economy when:

(a) aggregate demand is less than the full employment level of income
(b) injections exceed withdrawals at the full employment level of income
(c) the government has a budget surplus
(ix) The four main phases of business cycle are:

(a) boom, inflation, recession and recovery
(b) inflation, recession, recovery and boom
(c) recession, downturn, recovery and growth
(d) boom, downturn, recession and recovery
(x) Fiscal deficit can be controlled by:

(a) increasing taxes (b) reducing subsidies
(c) reducing public expenditure (d) all of the above
(xi) Demand curve slopes downward because of:

(a) consumer indifference (b) elasticity of demand
(c) inelastic demand (d) law of diminishing marginal utility
(xii) Which of the following best defines marginal utility?

(a) satisfaction of a want that results from consuming a good or service
(b) change in total utility as a result of consuming an additional unit of a product
(c) ability to buy more of a product or service when real income increases
(d) change in average satisfaction that results from consuming an additional unit of
a product
(xiii) Under perfect market conditions, the supply curve of a firm is the same as:
(a) MC curve (b) MR curve (c) AR curve (d) AC curve
(xiv) An option that protects profit after the underlying asset has experienced a significant
gain is called:
(a) forward (b) collar (c) swap (d) call option
(xv) An instrument whose price is dependent on one or more underlying asset(s) is called:
(a) share (b) certificate of deposit
(c) derivative (d) treasury bill
Section B
Q.6 (a) An increase in ‘GDP’ and ‘financial innovation’ are the two important factors that
influence the total demand for money in an economy.
Briefly explain with the help of suitable diagrams, how each of the above factors
affects the quantity of money demanded in an economy. (06)
(b) What is Keynesian liquidity trap? Identify any three policies which can help to break
out of the liquidity trap. (04)
Q.7 (a) What do you understand by the terms ‘floating exchange rate’ and ‘fixed exchange
rate’? List three advantages of each of the above types of exchange rates. (07)
(b) Identify the reasons why a government may want to influence exchange rate. (03)
Q.8 Analyse the effect of imposition / increase of indirect taxes on producers and consumers
and its relationship with the elasticities of demand and supply. (10)
Q.9 (a) Explain what is meant by the term ‘balance of payments deficit’. (03)
(b) Discuss the difference between ‘financing’ a balance of payments deficit and
‘correcting’ that deficit. (07)
Q.10 (a) Describe the four major objectives of a government’s economic policy. (06)
(b) What role does monetary policy play in achievement of the above objectives? (02)
(c) List any four tools that a central bank may use to implement its monetary policy. (02)
Q.11 (a) Draw a diagram of Circular Flow of Income. (04)

(b) List three types of ‘Withdrawals’ and ‘Injections’ from/into the Circular Flow of
Income. (03)
(c) Explain the effect of an increase in household savings rate on an economy. (03)
Q.12 (a) What is meant by the term ‘Recession’? What economic characteristics are commonly
observed during recessionary periods? (06)
(b) Briefly describe ‘Demand deficient unemployment’ and ‘Structural unemployment’. (04)
(THE END)
Suggested Answers
Section A
Ans.1 Price elasticity of supply

The degree of responsiveness of a change in supply of a commodity to change in its price,
keeping other factors constant is known as price elasticity of supply.
Types of elasticity of supply

(i) Perfectly inelastic (∑s = 0)
When supply of commodity remains fixed and is not affected by variations in price,
the elasticity of supply is said to be perfectly inelastic and its value is zero.
(ii) Inelastic (∑s < 1)

If percentage change in supply is less than the percentage change in price, the
supply is said to be inelastic and its value is less than one.
(iii) Unit elastic (∑s = 1)

If percentage change in supply is equal to percentage change in price, the elasticity
of supply is said to be unit elastic and its value is equal to one.
(iv) Elastic (∑s > 1)

If percentage change in supply is greater than percentage change in price, the
elasticity of supply is said to be elastic and its value is greater than one.
(v) Perfectly elastic (∑s = ∞)

When an extremely small rise in price leads to infinite extension in supply, the
elasticity of supply is said to be perfectly elastic and its value is infinity.
Determinants of price elasticity of supply

(i) If firms have large inventories of finished goods then they can draw on these to
increase supply following an increase in price of the good. Supply will therefore be
relatively elastic.
(ii) Firms can quickly and easily increase supply following an increase in price if they
have:
 spare capacity
 ability to switch resources to and from various production lines
In the above situations, the supply will be relatively elastic.
(iii) If it is easy to enter or exit from the market, the supply would be more elastic.
(iv) Supply is more elastic for goods with short production processes.
(v) The elasticity of supply also depends upon the time interval involved. For longer
time intervals, supply would be more elastic.
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Ans.2 (a) Fixed costs of a firm are those which do not vary with output. Fixed costs have to
be paid even when output is zero. The firm’s fixed costs are therefore the total cost
at zero output i.e. Rs. 110 million.
(b) Marginal revenue is defined as the addition to total revenue by producing one more
unit. Marginal revenue at each level of output is as follows:
Output 0 1 2 3 4 5 6 7 8
Total revenue - 50 100 150 200 250 300 350 400
Marginal revenue - 50 50 50 50 50 50 50 50
The marginal revenue is the same at all levels of output i.e. total revenue increases
by Rs. 50 each time an extra unit is produced. Marginal revenue is therefore
constant throughout and must be the same as average revenue, or price. Hence, the
demand curve is perfectly elastic which can happen only under conditions of perfect
competition.
(c) The firm aims to maximize profits and it will do this where the marginal revenue
gained from selling the last unit is equal to the marginal cost of producing that unit.
Output 0 1 2 3 4 5 6 7 8
Marginal revenue - 50 50 50 50 50 50 50 50
Marginal cost - 30 22 13 5 5 9 25 50
The output level at which marginal revenue equals marginal cost is 8 units, where
both MR and MC are Rs. 50. The firm will thus produce 8 units to earn maximum
profit i.e. Rs. 131 million.
Ans.3 (i) Allah is the sustainer: This describes the belief that God has created all the
resources available to man and is responsible for feeding and nourishing all the
creatures and human beings. Islam encourages people to do their best to earn a
livelihood using all lawful (Halal) and fair means whilst dissuading idleness.
(ii) God is the true owner of everything: Human beings are merely a trustee of
resources but have authority for using them but such authority is subject to certain
guiding principles that are required to be complied with.
(iii) State ownership: Islamic system neither proposes nor prohibits establishing state
owned enterprises. Therefore, a free market exists where entrepreneurs can profit so
long as they abide by the other rules of the Islamic economic system.
(iv) Practicing of moderation: Islam aims for a fair distribution of resources and so the
people are taught to share wealth where they can. In this regard, it proposes a
moderate life style and opposes extravagant as well as excessive misery.
(v) Prohibition of interest (Riba): Islamic economic system prohibits interest on
lending instead it encourages earning through profit and loss sharing.
(vi) Earnings: must only be made from goods and services which are permissible in
Islamic teachings.
(vii) Hoarding of wealth is discouraged: Though no limit is placed on the extent of
wealth that an individual can hold, yet, excessive wealth is discouraged through the
institutions of zakat and by encouraging charity and spending on welfare activities.
OR
Zakat: This is a financial tax on the wealth in order to aid the poor sections of the
society and helps in promoting fair distribution of wealth.
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Ans.4 (a) Features of a monopoly

The main features of monopoly are as follows:
 Monopolist is the sole supplier of a particular commodity or services.
 Monopolist is the price maker
 Monopolist earn super normal profit
 Monopolist offers a very high barrier/resistance to entry
Example of monopoly:
 Karachi Electric
 Pakistan Telecommunication Company Limited
 Water and Power Development Authority
 U.S. Steel
 Deutsche Telekom
 National Football League
(b) A monopolist keeps on producing as long as Marginal Revenue is greater than

Marginal Cost i.e. MR>MC.
As soon as marginal cost exceeds marginal revenue, profits will start declining.
Hence, the profit will maximize when MR=MC.
This can be clear from the following schedule:
Price or Margina
Averag Total Total Total Margina
Average l
Qty e Cost Revenue Cost Profit l Cost
Revenue Revenue
(Rs.) (Rs.) (Rs.) (Rs.) (Rs.)
(Rs.) (Rs.)
1 11.00 9.50 11.00 9.50 1.50 11.00 9.50
2 10.00 7.50 20.00 15.00 5.00 9.00 5.50
3 9.00 6.67 27.00 20.00 7.00 7.00 5.00
4 8.00 6.25 32.00 25.00 7.00 5.00 5.00
5 7.00 6.00 35.00 30.00 5.00 3.00 5.00
6 6.00 6.00 36.00 36.00 0.00 1.00 6.00
At quantity 4, the firm is in equilibrium where MR=MC i.e. Rs. 5.
Ans.5 (i) (b) determination of prices in the agricultural sector

(ii) (d) all of the above
(iii) (a) recovery
(iv) (c) Rs. 50,000
(v) (b) money market
(vi) (c) it gives opportunity to investors to invest in a diversified portfolio.
(vii) (b) buys the right to sell shares at a particular price
(viii) (a) aggregate demand is less than the full employment level of income
(ix) (d) boom, downturn, recession and recovery
(x) (d) all of the above
(xi) (d) law of diminishing marginal utility
(xii) (b) change in total utility as a result of consuming an additional unit of a product
(xiii) (a) MC curve
(xiv) (b) collar
(xv) (c) derivative
Page 3 of 10
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Section B
Ans.6 (a) Money demanded and an increase in GDP

When economic growth increases in the economy, there is an increase in incomes
as well as the number of people employed in the economy. This causes an increase
in the demand for money at each level of interest rate.
Consequently there is an outward shift in the demand for money.
Money demanded and an increase in financial innovation
Financial innovation incorporates new means of spending money such as credit

cards and debit cards, which reduce the need to withdraw cash in order to purchase
goods and services.
Consequently there is an inward shift in the demand for money.
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(b) Liquidity trap

Liquidity trap is a situation where savings rates are high despite very low interest
rates, causing monetary policy to be ineffective.
Policies that can help to break out of liquidity trap are as follows:
 Government through expansionary fiscal policy may raise the aggregate

demand.
 Raising inflation expectations may convince the people to spend.
 Central bank may convince the people of lower interest rates in the future.
Ans.7 (a) Floating exchange rate is the rate set by the unhindered forces of demand and
supply of the currency.
Fixed exchange rate is the rate set at a fixed parity against one or more foreign
currencies. In this case the government agrees to buy or sell at this rate to stop
fluctuations.
Advantages of floating exchange rates

 The need for government intervention in the foreign exchange markets is
eliminated.
 It helps to correct balance of payments disequilibrium.
 Frees the policy instruments of government to concentrate on internal issues
such as unemployment and inflation.
 Acts as a shock absorber. Variations in the rates of exchange act as a check
against invasion of the inflationary and deflationary forces.
Advantages of fixed exchange rates

 Avoids damaging speculation effect against the local currency
 Promotes trade as importers and exporters are protected from exchange rate
risks
 Government has to pursue responsible economic policies domestically
because excess aggregate demand and inflation would make it very difficult to
support the currency in the long term.
(b) A government may want to influence exchange rates in order to achieve the
following objectives:
(i) Stabilise the domestic currency against the pressures of short-term

speculation.
(ii) Stimulate demand for exports or to restrain imports.
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Ans.8 An indirect tax increases the cost of products. Its effect on the market place depends
upon the relative elasticities of demand and supply and the extent of the tax charge.
The market would either pass on the cost to consumers or to bear the affect by way
of a reduction in profit. At first consideration it might appear that a simple solution
of passing the entire amount of tax on to the consumer would be considered to be
appropriate.
The following diagram indicates the effects of indirect taxes on elasticity of demand
and supply.
As the diagram shows, the effect of the tax increase is indicated by a leftward shift
of the supply curve. This signifies that the firms in the market have incurred an
increase in costs, in this instance arising from the government demand that tax
should be raised on the sales of the goods in question. As can be seen, the
equilibrium price increases from P1 to P2 which results in a contraction in demand
from Q1 to Q2. The proportion of the tax paid by the consumers is the increase in
price attributable to the tax change. Obviously, this is the difference between P1 and
P2.
However, the consumers do not bear the entire burden of the tax. As shown on the
diagram the total tax increase is indicated by the vertical distance between the two
supply curves marked as ab. Thus, if the consumers are contributing P2-P1 (or ac)
the producers are contributing the rest, shown as cb.
The extent to which firms can pass on the tax increase depends upon the elasticity
of demand in relation to the elasticity of supply. Therefore,
 If the demand is inelastic or supply is elastic, the consumer would need to bear
the major portion of the burden of tax.
 If the demand is elastic or supply is inelastic, the producer would need to bear
the major portion of the burden of tax.
It may also note that the larger the elasticities of demand and supply for a good, the
greater will be the reduction in output following a rise in indirect taxation on that
good. If the combined elasticities are high, not only the firm will have to absorb
most of the tax increase itself but output will also fall resulting in a fall in total
revenue. This represents an additional burden on the producer.
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Ans.9 (a) A balance of payments deficit:
The balance of payments account records all the transactions between residents of a
country and residents of the rest of the world over a period of time. The account is
further bifurcated into current account and financial account. The current account
records all exports and imports of goods and services whereas the financial account
records inflows and outflows of capital.
Generally, a deficit in balance of payments usually refers to a current account

deficit that means the country has spent more on imports than it has received from
exports.
(b) Financing a balance of payments deficit

Financing a deficit involves the use of funds from the financial account to offset
deficits in the current account. These funds may be in the form of:
 gold and foreign currency reserves;

 borrowings from overseas banks or other international lenders like IMF and
World Bank, etc.
Correcting the balance of payments deficit

A country’s borrowing power obviously is not infinite. Therefore, measures have to
be taken to correct a balance of payments deficit. These include:
 exchange rate depreciation

 deflation by bringing down the domestic price level. This can increase the
attractiveness of goods on the international market, thereby increasing
exports.
 exchange control – e.g. a monetary authority may direct exporters to
relinquish foreign exchange reserves to the central bank.
 imposition of tariffs on import
 fixation of quotas on import of goods
 Helping the exporters to sell their goods and services by organizing exhibitions
and trade fairs
 Curtailing the level of imports by producing the required goods domestically
In conclusion, financial measures are short term methods of dealing with balance of
payments deficits. Corrective measures must be applied to correct long-term deficit.
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Ans.10 (a) The four major objectives of the government economic policies are:
(i) To achieve economic growth:

A major objective of the government’s economic policy is to achieve
economic growth and increase the per capita national income. This way the
GDP level will rise resulting in improvement in standards of living of the
people, higher production and increase in tax collection.
(ii) To control inflation:

To have a stable price level is important so that the real income of the people
can increase with the passage of time and the standard of living can rise too.
(iii) To achieve full employment:

This is also an important objective as the government has to pay
unemployment benefits to the people. If there is full employment then the
government will save that money and also be able to collect more taxes. This
would help the government to increase provision of public and merit goods.
There will also be a high standard of living of the people.
(iv) To achieve a balance between imports and exports:

Deficit in the BOT is harmful for a country’s economy. Economic growth
would stop as more imports would mean that local industries are suffering
from severe competition from abroad.
(b) Through monetary policy, government increases interest rate and restricts money
supply to curb inflation. However, an undue increase in interest rate and undue
restriction on money supply results in lowering growth and investment. Hence, the
government endeavours to achieve a balance by allowing a reasonable inflation to
exist so that growth, employment and balance between imports and exports do not
suffer.
(c)  Open market operations

 Credit rationing/reserve requirements
 Bank rate policy/discount rate policy
 Exchange rates policy
 Moral persuasion
 Credit regulation
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Ans.11 (a)
(b) Three types of withdrawals from the circular flow of income:

(i) Savings
(ii) Taxation
(iii) Imports
Three types of injections into the circular flow of income:

(i) Investments
(ii) Government spending
(iii) Exports
(c) Savings represent a withdrawal from the circular flow of income. An increase in
household savings increases the pool of funds available for investment which may
lead to a fall in interest rates, but also reduces the spending of households and
therefore reduce the demand for the goods and services produced by firms.
A decrease in interest rates reduces the cost of borrowing for firms but the reduction
in demand may have a serious effect on sales. The extent of the effect will depend
on the type of product, as those for which demand may be postponed will be the
worst affected.
Ans.12 (a) A Recession is a recurring period of decline in total output, income and
employment and usually prevails for a period of 6-12 months. It is marked by a
period of decline in aggregate demand and widespread contraction of many sectors
of the economy.
The economic characteristics which are most commonly observed during a

recessionary period are:
(i) decline in demand for labour followed by layoffs and increase in

unemployment rates.
(ii) fall in demand for capital goods, consumer durable goods and luxury items
and downward trend in their prices.
(iii) sharp drop in business profits.
(iv) decline in volume of shares traded in the stock exchanges and fall in their
prices.
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(v) decline in the demand for credit accompanied by drop in interest rates.
(b) Demand-deficient unemployment: When an economy is in recession or a period of

low growth, aggregate demand may be deficient to meet the potential output in an
economy. Firms therefore cutback production and reduces the amount of labour
that is required.
Structural unemployment: arises though inefficiencies in the labour market. This

often occurs through a misalignment of skill sets in certain geographical locations.
It is more prominent if labour is unwilling to move geographically in search of new

work, or if firms are unwilling to take on people with different skill sets.
(THE END)
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Certificate in Accounting and Finance Stage Examination

The Institute of 24 September 2020

Introduction to Economics and Finance

(ii) Micro economics does NOT cover:

(iii) Which of the following statements is NOT correct?

(v) Which of the following is NOT considered to be an assumption of the law of

(a) Equality (b) Economy

(ix) Which of the following would increase the value of multiplier?

(x) The crowding out effect is caused by a:

(a) Corporate bonds (b) Mutual funds

(xiv) A country’s balance of payment position exhibits:

(xv) Which of the following is a financial intermediary?

(b) Describe any three limitations of multiplier. (03)

(b) What do you understand by the ‘Quantity theory of money’? (03)

(c) Describe the functions of money. (03)

(b) Briefly discuss the constituents of capital/financial account. (04)

Ans.1 (a) Planned economy:

Drawbacks of planned economy:

(b) Capital formation:

Stages involved in the process of capital formation

(i) Creation of savings:

(ii) Mobilization of savings:

(iii) Investment of savings:

Ans.2 (a) Law of diminishing marginal utility:

Explanation with the help of schedule and a graph:

Units of commodity Total utility Marginal utility (MU)

(b) Factors which may determine price elasticity of demand:

Ans.3 (a) Economies of scale:

Internal economies of scale can be achieved in the following ways:

(ii) Managerial economies:

(iii) Trading/commercial economies:

(iv) Financial economies:

The above diagram demonstrates the concept of consumer equilibrium using

Ans.5 (i) (a) An incentive to innovate

Ans.6 (a) Circular flow of national income in a two-sector economy:

(b) (i) Factors causing a shift in aggregate demand curve:

(ii) Factors causing a shift in short-run aggregate supply curve:

Ans.7 (a) Cost-push inflation:

Causes of cost-push inflation:

(i) Rising labour costs:

(ii) Expectations of inflation:

(iii) Component costs:

(iv) Higher indirect taxes:

(b) Limitations of Multiplier:

(i) Efficiency of production/Elasticity of supply:

(ii) Regular investment:

An increase in government spending causes aggregate demand (AD) to shift outward to

However, equilibrium at point B is unsustainable. To produce this level of output there

Ans.9 (a) Progressive taxation:

(b) Characteristics of a good tax policy:

(c) Objectives of fiscal policy:

(ii) Resource mobilization: Fiscal mechanism attempts at resource mobilization

(iii) Resource allocation: A fair share of resources is allocated to different sectors

(iv) Economic stability: Undesired pace of inflation or deflation is controlled by

(v) Income distribution: Fiscal policy is a combination of taxation and relief

(i) Issuer of currency:

(ii) Banker to the government:

(iii) Regulator of the banks:

(iv) Exchange rate controls:

(v) Establishment of specialized banks:

(b) Quantity theory of money:

Ans.11 (a) Keynesian liquidity trap

low interest rates, causing monetary policy to be ineffective.